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Spatial pricing patterns and market power ; Theory and evidence from the BC interior pulp fibre market Nelson, Harry 1999

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In presenting this  thesis  in partial fulfilment  of  the  requirements  for  an advanced  degree at the University of British Columbia, I agree that the Library shall make it freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the head of my department  or  by  his  or  her  representatives.  It  is  understood  that  copying  or  publication of this thesis for financial gain shall not be allowed without my written permission.  Department of The University of British Columbia Vancouver, Canada  7  DE-6 (2/88)  SPATIAL PRICING PATTERNS A N D M A R K E T POWER: THEORY A N D E V I D E N C E F R O M T H E BC INTERIOR P U L P FIBRE MARKET by H A R R Y NELSON  A THESIS SUBMITTED IN PARTIAL F U L F I L L M E N T OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY In T H E F A C U L T Y OF G R A D U A T E STUDIES The Faculty of Forestry Department of Forest Resources Management We  a c c e p t t h i s thesis as c o n f o r m i n g T o the r e q u i r e d s t a n d a r d  T H E UNIVERSITY OF BRITISH COLUMBIA J u l y 1999  © H a r r y N e l s o n 1999  A B S T R A C T  T h e large scale and transportation costs o f most w o o d p r o d u c i n g industries, e s p e c i a l l y i n the p u l p and paper sector, t y p i c a l l y leads to h i g h levels o f concentration i n regional markets f o r w o o d fibre. T h i s i n turn has meant that the possible exercise o f market p o w e r i n forest product input and output markets has been l o n g r e c o g n i z e d . A recurring issue i n B r i t i s h C o l u m b i a has been the prices p a i d b y l o c a l p u l p m i l l s for w o o d chips used to produce p u l p . T h e p r o v i n c i a l government has directly and i n d i r e c t l y regulated the p u l p fibre market i n the Interior o f the p r o v i n c e both d u r i n g its i n c e p t i o n and throughout m u c h o f the past forty years. G o v e r n m e n t intervention l e d to a non-competitive outcome m a r k e d b y l o w prices for w o o d chips that were characterized b y the fact that prices p a i d to suppliers were invariant w i t h respect to distance. A m o d e l shows h o w this particular e q u i l i b r i u m w a s inherently unstable, as e v i d e n c e d b y prices increasing four-fold after a change i n firm b e h a v i o u r .  B e c a u s e the p r o v i n c e o w n s o f most o f the forest l a n d i n the p r o v i n c e it has developed a set o f goals c o n c e r n i n g the p r o v i n c i a l forest industry that i n c l u d e p r o v i d i n g e m p l o y m e n t , m a i n t a i n i n g c o m m u n i t y stability, and c o l l e c t i n g revenues f r o m the harvest o f t i m b e r o n behalf o f the p u b l i c . T h e p r o v i n c i a l government faces a series o f p o l i c y questions regarding the forest industry i n terms o f harvest l e v e l s , regulation, trade p o l i c y , a n d stumpage design. I f past trends continue, p u l p and paper m i l l s are l i k e l y to b e c o m e the largest users o f the forest resource w i t h i n the next five years, w h i l e p r o v i n c i a l forest p o l i c y remains focused o n the p r o d u c t i o n o f s o l i d w o o d products. A t the same time, increased fibre costs due to a c o m b i n a t i o n o f government initiatives and decreasing fibre availability are affecting the entire forest industry i n B C . F o r p u l p and paper m i l l s their fibre costs c a n determine their competitiveness i n w o r l d markets. H o w the government responds to these issues w i l l affect both fibre f l o w s w i t h i n the sector as w e l l as the future structure o f the forest sector.  Key Words: price d i s c r i m i n a t i o n , p u l p , w o o d c h i p s , m a r k e t p o w e r , B r i t i s h C o l u m b i a  Table of Contents ABSTRACT  II  TABLE OF CONTENTS  Ill  LIST OF T A B L E S  VI  LIST O F FIGURES  VII  ACKNOWLEDGEMENTS  IX  INTRODUCTION....  1.  1  T H E D E V E L O P M E N T O F T H E W O O D C H I P M A R K E T IN T H E B R I T I S H  INTERIOR  5  W H A T IS A W O O D C H I P ?  5  D E V E L O P M E N T O F W O O D C H I P S AS A F I B R E S O U R C E  5  T H E F O R E S T I N D U S T R Y IN BRITISH C O L U M B I A  :  7  P A T T E R N S O F R E S O U R C E U S E IN B C  11  S T R U C T U R E O F T H E B C INTERIOR W O O D C H I P M A R K E T  16  P U L P I N G PROCESSES  18  H I S T O R I C A L D E V E L O P M E N T O F T H E INTERIOR P U L P INDUSTRY  22  T H E DEVELOPMENT OF PULPWOOD HARVESTING AGREEMENTS  23  T H E M O V E TO C L O S E UTILIZATION STANDARDS  25  T H E INTRODUCTION O F CHIP DIRECTION POLICY  28  T H E INTRODUCTION O F M I N I M U M C H I P PRICING A N D E X P O R T RESTRICTIONS  29  T H E R O Y A L COMMISSION O N FOREST RESOURCES  32  T H E F O R M A T I O N O F F I B R E C O EXPORT INC  38  T H E F O R E S T A C T O F 1978  41  CHIP DIRECTION POLICY DROPPED  41  T H E GRANTING OF NEW' PULPWOOD AGREEMENTS  46  'CHIP SHOCK'  47  V  2.  COLUMBIA  REVIEW OF ECONOMIC THEORY  54  M A R K E T P O W E R A N D PRICE DISCRIMINATION  54  M O D E L S OF PULPWOOD M A R K E T S  58  M O D E L S O F SPATIAL PRICING A N D M A R K E T P O W E R  60  D E L I V E R E D PRICING S Y S T E M S FIRM BEHAVIOUR A N D T H E EFFECT ON M A R K E T OUTCOMES  '.  68 71  iii  EMPIRICAL INVESTIGATIONS O F N O N C O M P E T I T I V E B E H A V I O R  74  S T U D I E S O F S P A T I A L PRICE D I S C R I M I N A T I O N  81  SUMMARY  3.  :  M O D E L I N G T H E INTERIOR  W O O D  CHIP  M A R K E T . . . .  84  S U P P L Y O F S I N G L E A N D J O I N T PRODUCTS  84  S O U R C E S O F H E T E R O G E N E I T Y I N W O O D CHIPS  85  E Q U I L I B R I U M W I T H J O I N T PRODUCTION  „  86  INPUT PRICES U N D E R D I F F E R E N T S U P P L Y C O N D I T I O N S  88  INTEGRATING D E M A N D A N D SUPPLY  94  A M O D E L O F PRICE DISCRIMINATION IN A W O O D C H I P M A R K E T  95  A M O D E L O F T H E INTERIOR W O O D C H I P M A R K E T  99  T H E I M P O R T A N C E O F PUNISHMENT P A T H S I N D E T E R M I N I N G N A S H E Q U I L I B R I A  4. T E S T S  O F P R I C E  C O L U M B I A  5.  82  D I S C R I M I N A T I O N  IN T H E W O O D  CHIP  INTERIOR  M A R K E T  121  IN T H E  BRITISH 128  TESTS OF M A R K E T PRICE L E V E L S  128  T E S T I N G F O R C H A N G E S I N M A R K E T PRICE L E V E L S  134  RESULTS FROM TESTING FOR C H A N G E S IN PRICE L E V E L S  135  TESTS O F F I R M PRICES A N D PRICING P A T T E R N S  137  TESTING FOR F O R M U L A PRICING  137  M O D E L E S T I M A T I O N A N D DISCUSSION O F T H E R E S U L T S  140  M A R K E T POWER A N D FIRM REACTIONS  145  ESTIMATING RESPONSE FUNCTIONS  146  EXAMINING FIRM INTERACTION  147  M O D E L I N G F I R M INTERACTION  149  RESULTS FROM ESTIMATING F I R M INTERACTION  150  SUMMARY  154  T H E P O L I C Y  I M P L I C A T I O N S  O F M A R K E T  P O W E R .  161  G L O B A L T R E N D S IN D E M A N D F O R P U L P F I B R E  162  P R O V I N C I A L F O R E S T P O L I C Y INITIATIVES  164  IMPACTS O F F O R E S T P O L I C Y INITIATIVES .'.  166  T E N U R E POLICY  167  STUMPAGE POLICY  169  T H E INTERACTION B E T W E E N F O R M U L A PRICING A N D F I R M B E H A V I O R  172  T H E E F F E C T O F IMPERFECT M A R K E T S O N S O C I A L W E L F A R E  173  INVESTMENT A N D ESTIMATES OF R E N T  174  iv  CONSEQUENCES OF UNCOLLECTED R E N T  177  6. CONCLUSIONS  180  REFERENCES  189  APPENDIX A . D A T A SOURCES  206  V  List of Tables  T a b l e 1. B r i t i s h C o l u m b i a M a t u r e Standing T i m b e r V o l u m e s as o f 1996  8  T a b l e 2. L u m b e r and P u l p P r o d u c t i o n i n B C  12  Table 3. Residual C h i p Production i n B C , by R e g i o n  13  T a b l e 4. E x p o r t s o f W o o d C h i p s f r o m B C b y R e g i o n for Selected Y e a r s  13  T a b l e 5. Estimates o f the P r i m a r y B r e a k d o w n o f H a r v e s t i n B C f r o m 1990 to 1996  14  T a b l e 6. A n n u a l C u t t i n g R i g h t s b y C o m p a n y  17  T a b l e 7. Interior P u l p C a p a c i t y b y M i l l and L o c a t i o n , Selected Y e a r s  21  T a b l e 8. E s t i m a t e d C h i p R e c o v e r y Factors i n the B C Interior 1987-95  90  T a b l e 9. C o r r e l a t i o n B e t w e e n P r o d u c t P r i c e s and C h i p R e c o v e r y P r o x i e s  93  T a b l e 10. F i r m Payoffs U n d e r Different P r i c i n g Strategies  110  T a b l e 11. Potential G a i n s f r o m D e v i a t i o n  130  T a b l e 12. M a r g i n as a F u n c t i o n o f D e m a n d and M a r k e t P o w e r  136  T a b l e 13. E s t i m a t i n g W o o d C h i p P r i c e s as a F u n c t i o n o f Product Prices and D i s t a n c e  141  T a b l e 14. R e p o r t e d A v e r a g e C h i p V a l u e s i n the N o r t h e r n Interior i n 1994 and 1996  144  T a b l e 15. P r i c e B e h a v i o u r U n d e r A s s u m e d P r i c e C o o r d i n a t i o n  151  T a b l e 16. P r i c e B e h a v i o u r D u r i n g R e v e r s i o n a r y P e r i o d  .152  T a b l e 17. Estimates o f R e n t and Charges O v e r T h r e e Different P e r i o d s  176  T a b l e 18. Estimates o f R e n t and C h a r g e s o n a per c u b i c metre B a s i s  177  T a b l e 19. R e t u r n o n C a p i t a l E m p l o y e d b y Product  178  vi  List of Figures F i g u r e 1. H a r v e s t b y R e g i o n i n B C f o r Selected Y e a r s  11  F i g u r e 2 . Interior Forest P r o d u c t P r i c e s A d j u s t e d for Inflation, 1 9 7 0 - 1 9 9 6  15  F i g u r e 3 . L o c a t i o n o f P u l p M i l l s i n the B C Interior.  20  F i g u r e 4 . P r i c i n g U n d e r C o m p e t i t i v e C o n d i t i o n s and U n d e r a M o n o p s o n y  56  Figure 5. Price Discrimination in a W o o d C h i p Market  62  F i g u r e 6. Increasing P r i c e D i s c r i m i n a t i o n as D e m a n d B e c o m e s M o r e Inelastic  65  F i g u r e 7 . Increased C o m p e t i t i o n f r o m F i r m E n t r y R e d u c e s P r i c e D i s c r i m i n a t i o n  65  F i g u r e 8. Increased C o m p e t i t i o n f r o m O v e r l a p p i n g M a r k e t A r e a s Increases D i s c r i m i n a t i o n  67  F i g u r e 9 . P r i c i n g w i t h and without C a p a c i t y C o n s t r a i n t s  79  F i g u r e 10. S u p p l y C u r v e for R e s i d u a l C h i p s w i t h Reservation P r i c e B a s e d o n L u m b e r Prices  92  Figure 11. C h i p Recovery by Region 1993-95.  93  F i g u r e 12. M a r k e t P o w e r i n a W o o d C h i p M a r k e t w i t h and w i t h o u t D i s c r i m i n a t o r y P r i c i n g  92  F i g u r e 1 3 . S a w m i l l a n d D e l i v e r e d P r i c e s for Different S a w m i l l s a n d P u l p M i l l s i n the Interior for the T h i r d Quarter o f 1989  97  F i g u r e 14. S a w m i l l and D e l i v e r e d P r i c e s for Different S a w m i l l s and P u l p M i l l s i n the Interior f o r the T h i r d Quarter o f 1990  98  F i g u r e 15. G a m e Tree f o r F i r m s that E i t h e r C o m m i t to P r i c e U n i f o r m l y o r Retain T h e i r F r e e d o m to P r i c e Discriminate  104  F i g u r e 16. B a s i n g P o i n t P r i c i n g w i t h F i r m 1 the P r i c e L e a d e r .  105  F i g u r e 17. D i s c r i m i n a t o r y P r i c i n g b y F i r m 1 a n d F i r m 2  112  F i g u r e 18. U n i f o r m P r i c i n g b y F i r m 1 and F i r m 2  113  vii  F i g u r e 2 0 . A c t u a l and Constructed P r i c e Series f o r W o o d C h i p s i n the B C Interior  127  F i g u r e 2 1 . Relative P r i c e C h a n g e s i n Three W o o d C h i p M a r k e t s .  132  F i g u r e 2 2 . Relative C h a n g e i n P r i c e s and P r o d u c t i o n 1 9 8 7 - 1 9 %  133  F i g u r e 2 3 . L u m b e r and C h i p V a l u e s per c u b i c metre o f L o g Input and Stumpage as Percentage o f L o g V a l u e s i n the Interior F i g u r e 2 4 . A n n u a l R e n t i n B r i t i s h C o l u m b i a and T i m b e r C h a r g e s i n 0 0 0 ' s o f D o l l a r s  170 176  viii  Acknowledgements T h i s thesis w o u l d not have b e e n p o s s i b l e w i t h o u t the support o f m y w i f e , Joanne. I w o u l d l i k e to thank her for her patience i n seeing m e through this (at times interminable) process, as w e l l as her support. I w o u l d also l i k e to thank m y parents for their support throughout m y a c a d e m i c years. I w o u l d also l i k e to thank a l l those people i n the industry and government officials w h o gave generously o f their time and shared their expertise.  F i n a l l y , I w o u l d l i k e to dedicate this thesis to B a n n o c k . i \  ix  Introduction T h i s thesis examines the development and structure o f the residual w o o d c h i p market i n the Interior o f B r i t i s h C o l u m b i a ( B C ) o v e r the p e r i o d 1961 to 1996. S i n c e the i n c e p t i o n o f the p u l p and paper industry i n the Interior, w o o d c h i p prices w i t h i n the r e g i o n have been a recurring issue that has r e c e i v e d government attention. A n u m b e r o f authors have noted that c h i p prices r e c e i v e d b y s a w m i l l s i n this r e g i o n are thought to be "too l o w " or "uncompetitively l o w " and have attributed these l o w prices to imperfectly competitive markets. T h i s issue warrants i n v e s t i g a t i o n f o r several reasons. 1  First, despite its l o w profile, the market is quite substantial i n size. M e a s u r e d b y the v a l u e o f shipments i n 1996, the Interior w o o d c h i p m a r k e t exceeded the G D P o f agriculture, f i s h i n g a n d trapping, p e t r o l e u m and natural gas, and c o a l i n B C ( B C Stats 1998). D e s p i t e the importance o f this market, it is p o o r l y understood b y those people w h o are not d i r e c t l y i n v o l v e d i n the industry, i n part due to a dearth o f p u b l i c i n f o r m a t i o n . T h e market is the largest w o o d fibre market w i t h i n the p r o v i n c e (as w e l l as the largest r e g i o n a l market f o r p u l p fibre i n C a n a d a ) . V i r t u a l l y nonexistent forty years ago, the market today provides the b u l k o f the fibre f o r the fourteen p u l p and paper m i l l s w i t h i n the r e g i o n as w e l l as significant amounts to both the C o a s t a l industry as w e l l as the export market. It also serves as a n important market f o r one o f the m a i n co-products o f the s a w m i l l industry i n B C .  S e c o n d , the w o o d c h i p market provides a n opportunity to e x a m i n e h o w government intervention c a n frustrate n o r m a l market processes and lead to n o n - c o m p e t i t i v e outcomes. T h e w o o d c h i p market has faced at various times direct controls o n prices, restrictions o n exports, and constraints o n w h e r e domestic v o l u m e s c o u l d be sold. T h e s e p o l i c i e s have  1  See M a h o o d ( 1990:195) and Bernsohn (1981:98), w h i c h make reference to l o w c h i p prices. A n Interior newspaper refers to c h i p prices less than half o f those paid i n the B C Coast market (Citizen 1974). In addition, W o o d b r i d g e (1984) and N i l s s o n (1985) note that residual chips sell for substantially less than roundwood chips on the B C Coast and predict that residual c h i p prices w i l l move up to roundwood prices. A t the time, Interior prices for residual chips were below Coastal prices. 1  also appeared to various degrees i n other parts o f the forest sector, most n o t i c e a b l y constraints o n l o g exports. H o w these p o l i c i e s have i n f l u e n c e d the d e v e l o p m e n t o f the w o o d c h i p market illustrates some o f the potential shortcomings o f government intervention. I n a d d i t i o n , the issues i n v o l v e d i n the p r i c i n g o f p u l p fibre have l o n g been a c o n c e r n o f forest p o l i c y makers throughout C a n a d a and other parts o f the w o r l d .  F i n a l l y , it has l o n g been debated whether d e l i v e r e d p r i c i n g systems (formulas that e x p l i c i t l y calculate prices based o n the geographic l o c a t i o n o f the producer o r customer) facilitate or hinder c o m p e t i t i o n . I n this case, a detailed data set o n i n d i v i d u a l f i r m prices a n d a relatively static industry structure c a n shed light o n the issues i n v o l v e d i n such systems a n d show that, based o n the evidence f r o m this market, d e l i v e r e d p r i c i n g systems do facilitate c o l l u s i v e outcomes through p e r m i t t i n g f i r m s to coordinate prices.  T h i s thesis has the f o l l o w i n g objectives: •  T o explore the development o f the Interior w o o d c h i p market;  •  T o develop a m o d e l to e x a m i n e the p r i c i n g p o l i c i e s e m p l o y e d i n the w o o d c h i p market; and  •  T o investigate the p o l i c y consequences o f both market p o w e r and government intervention i n the Interior w o o d c h i p market.  In terms o f m e t h o d o l o g y , the thesis w i l l : •  r e v i e w the development o f the w o o d c h i p market i n the B C Interior, i n c l u d i n g specific p o l i c i e s geared towards the w o o d c h i p market;  •  r e v i e w the e c o n o m i c literature regarding p u l p fibre markets and market p o w e r , concentrating o n price discrimination;  •  develop a m o d e l o f the Interior w o o d c h i p market a n d test it f o r evidence o f market p o w e r ; and  •  discuss the results and the i m p l i c a t i o n s f o r future p u b l i c p o l i c y .  T h e thesis relies o n a large data set o n w o o d c h i p prices c o l l e c t e d by the M i n i s t r y o f Forests w h i c h surveys w o o d c h i p prices i n the B C Interior as part o f the stumpage appraisal process. It w a s supplemented by additional i n f o r m a t i o n c o l l e c t e d i n a series o f i n t e r v i e w s w i t h c o m p a n y executives after access to the p r o v i n c i a l data base was terminated. T h e p r i m a r y data set is l i m i t e d to transactions between independent s a w m i l l s a n d p l y w o o d m i l l s and p u l p m i l l s . Information o n the identity o f purchasers was d i s c o n t i n u e d i n early 1995 due to a change i n government p o l i c y . T h i s required the c o l l e c t i o n o f i n f o r m a t i o n o n prices f r o m c o m p a n y executives d i r e c t l y , and as a result, the data c o l l e c t e d covers a s m a l l e r set o f purchasers through the first t w o months o f 1996 ( w h i c h covers the market peak). T h e data set o n prices i s also supplemented by additional data f r o m other sources o n prices i n other markets as w e l l as relevant p r o d u c t i o n statistics.  T h e thesis provides an extensive description o f market p o w e r i n the f o r m o f p r i c e d i s c r i m i n a t i o n , w h i c h occurs w h e n different customers (suppliers) pay (receive) different prices for the same g o o d , after a l l adjustments f o r any differences i n the g o o d , such as quality or transportation costs, have been taken into account. T h e thesis focuses o n a particular type o f price d i s c r i m i n a t i o n that falls i n the general category o f delivered pricing systems. T h e s e p r i c i n g systems are characterized b y prices that are determined b y some geographic f o r m u l a ; for e x a m p l e , a customer's price m a y be determined as the price o f a g o o d d e l i v e r e d f r o m a s p e c i f i e d point under basing p o i n t p r i c i n g (e.g. " P i t t s b u r g h p l u s " ) , even i f the g o o d does not c o m e f r o m that l o c a t i o n . E c o n o m i s t s have l o n g debated, w i t h i n c o n c l u s i v e results, whether such systems reflect c o m p e t i t i v e or c o l l u s i v e b e h a v i o u r .  T h e thesis shows that i n this case, the particular d e l i v e r e d p r i c i n g system e m p l o y e d i n the B C Interior w o o d c h i p market cannot be e x p l a i n e d b y m o d e l s o f c o m p e t i t i v e b e h a v i o u r . Rather, the p r i c i n g system reflects a non-competitive outcome that was sustained through  tacitly collusive behaviour until very recently. I n general, it appears that d e l i v e r e d p r i c i n g systems c a n hinder c o m p e t i t i o n through reducing uncertainty about  firm-specific  prices through the use o f c o m m o n price-setting formulae b y a l l rivals and e n a b l i n g f i r m s to coordinate prices.  T h e thesis concludes w i t h an e x a m i n a t i o n o f the consequences o f government regulation a n d intervention i n the development o f the w o o d c h i p market. It also discusses some o f the issues that arise i n the p u l p fibre market that need to be taken into consideration i n d e v e l o p i n g future forest p o l i c y i n B C .  1. The Development of the Wood Chip Market in the British Columbia Interior What is a Wood Chip? W o o d c h i p s are produced b y the b r e a k d o w n o f slabs a n d other pieces o f s o l i d w o o d that are produced d u r i n g the manufacture o f l u m b e r .  2  These pieces are f e d into a c h i p p e r that turns the  irregularly sized pieces into smaller, m o r e u n i f o r m pieces o f w o o d a p p r o x i m a t e l y the size o f a m a t c h b o o k c a l l e d w o o d chips. D e p e n d i n g o n the nature o f the s a w m i l l , these chips c a n be directly c o n v e y e d to w a i t i n g trucks, r a i l cars, barges, o r put into storage bins o r stockpiles outside, where they c a n be reloaded onto the appropriate v e h i c l e f o r d e l i v e r y to customers (pulp and paper m i l l s ) . B e c a u s e o f variations i n species a n d moisture content, w o o d chips are u s u a l l y expressed i n terms o f a standardized measurement based o n weight. I n the Interior o f B r i t i s h C o l u m b i a , the m o s t c o m m o n unit i s the B o n e - D r y U n i t ( B D U ) , w h i c h i s the v o l u m e o f w o o d c h i p s that w i l l w e i g h 2 4 0 0 pounds (1089 k i l o g r a m s ) after i t has been o v e n - d r i e d to a constant w e i g h t ( B i e r m a n n 1996). W o o d chips c a n also be p r o d u c e d b y c h i p p i n g w h o l e logs, u s i n g s p e c i a l i z e d equipment, o r through the use o f s m a l l m o b i l e c h i p p i n g machines o n the l o g g i n g site. W h o l e l o g chips are c o m m o n l y referred to as " r o u n d w o o d " c h i p s , referring to the manufacturing process, c o m p a r e d to the chips p r o d u c e d as a co-product d u r i n g the manufacture o f s o l i d w o o d products w h i c h are c o m m o n l y c a l l e d " r e s i d u a l " chips.  Development of Wood Chips as a Fibre Source T h e use o f w o o d c h i p s b y the p u l p a n d paper industry w a s first pioneered i n the P a c i f i c N o r t h w e s t i n Port A n g e l e s . P u l p a n d paper m i l l s w i t h i n the r e g i o n h a d o r i g i n a l l y r e l i e d o n large o l d g r o w t h western h e m l o c k (Tsuga heterophylla ( R a f . ) Sarg.) to p r o v i d e their raw material. T h i s bright w o o d w a s particularly w e l l suited to the p r e v a i l i n g sulfite p u l p i n g process i n existence at that time.  2  F o r a typical cubic metre o f solid w o o d input, an Interior sawmill w i l l produce approximately 2 5 0 board feet o f lumber or 5 0 % o f the l o g ; .15 B D U s o f chips or 3 0 % o f the l o g , w i t h the remaining 20% sawdust and hog fuel ( K u a n 1997).  i  5  S a w m i l l s were o n l y interested i n the higher value o l d growth D o u g l a s - f i r (Pseudotsuga menziesii ( M i r b . ) F r a n c o var. m e n z i e s i i ) , a n d p u l p a n d paper m i l l s c o u l d acquire abundant quantities o f h e m l o c k f o r little more than the cost o f h a u l i n g l o g s out o f the bush. A s the valuable o l d g r o w t h stands o n the W e s t C o a s t were l o g g e d , s a w m i l l e r s shifted into less accessible parts o f the region a n d started u t i l i z i n g different species, i n c l u d i n g western h e m l o c k .  Increasing c o m p e t i t i o n for h e m l o c k logs l e d p u l p and paper m i l l s to search f o r alternative fibre supplies. T h i s resulted i n the use o f r e s i d u a l w o o d waste ( m a i n l y w o o d chips) f r o m the s a w m i l l s w i t h i n the P a c i f i c N o r t h w e s t ( W a s h i n g t o n , O r e g o n , a n d the B C C o a s t ) as a source o f furnish starting i n the 1930s. T h i s w a s encouraged b y the d e v e l o p m e n t o f the K r a f t p u l p i n g process, w h i c h p r o v i d e d a technology that c o u l d easily a c c o m m o d a t e the w i d e varieties o f species w i t h i n the r e g i o n , a n d the P a c i f i c N o r t h w e s t s a w sulfite a n d g r o u n d w o o d m i l l s gradually replaced b y K r a f t m i l l s . A b u n d a n t s a w m i l l residue p r o v i d e d a cheap source o f fibre f o r the p u l p a n d paper m i l l s a n d supplied a g r o w i n g p r o p o r t i o n o f their furnish f o r m i l l s i n the U S P a c i f i c Northwest, i n c r e a s i n g l y d i s p l a c i n g the use o f p u l p l o g s (Carrothers 1938). I n the 1940s t w o n e w p u l p m i l l s opened o n V a n c o u v e r Island (the B l o e d e l m i l l at Port A l b e r n i a n d the H a r m a c m i l l i n N a n a i m o , b o t h still operating today). T h e y were the first to u t i l i z e w o o d chips w i t h i n B C ( W e l l b u r n 1996). B y the 1950s, then, w o o d chips h a d been p r o v e n as a t e c h n o l o g i c a l l y feasible source o f f i b r e .  T h e d e v e l o p m e n t o f engineered w o o d products, s u c h as O r i e n t e d Strand B o a r d ( O S B ) a n d M e d i u m Density F i b r e b o a r d ( M D F ) i n recent years, has increased the d e m a n d f o r w o o d c h i p s a n d m a r g i n a l w o o d fibre, l e a d i n g p u l p a n d paper m i l l s to a g a i n search f o r less costly alternative supplies o f fibre. F o r e x a m p l e , some Interior p u l p producers n o w use sawdust to manufacture short-fibred p u l p , w h i l e others have either b u i l t plants o r adapted some o f their processing capacity to use s u c h h a r d w o o d species as c o t t o n w o o d (Populus balsamifera ssp. Trichocarpa ( T o r r . & G r a y ex H o o k ) B r a y s h a w ) a n d aspen (Populus tremuloides M i c h x ) .  6  I n 1996, r e s i d u a l fibre f r o m s a w m i l l s made up s l i g h t l y less than 7 0 % o f a l l fibre c o n s u m e d b y p u l p m i l l s i n C a n a d a ( e x c l u d i n g r e c y c l e d pulp), up f r o m s l i g h t l y m o r e than 4 0 % at the b e g i n n i n g o f 1980 ( C P P A 1996). W i t h i n the U n i t e d States, residual furnish m a k e s up 4 1 % o f a l l fibre c o n s u m e d ; w i t h i n the P a c i f i c N o r t h w e s t , the p r o p o r t i o n is h i g h e r at 6 5 % ( A P A various years). W i t h i n the B C Interior, residual chips m a k e up 8 4 % o f the fibre needs o f p u l p and paper m i l l s ( N e l s o n et a l . 1997). S u c h a h e a v y reliance o n s a w m i l l residual chips has t i g h t l y b o u n d the t w o industries together m o r e so than anywhere else i n North America.  B e f o r e e m b a r k i n g o n a description o f the w o o d c h i p market, it is helpful to understand the resource base that underlies the s a w m i l l i n g and p u l p and paper sector w i t h i n the p r o v i n c e ofBC.  The Forest Industry in British Columbia The Resource T h e P r o v i n c e o f B r i t i s h C o l u m b i a ( B C ) covers 9 5 . 2 m i l l i o n hectares, o f w h i c h 60.3 m i l l i o n hectares are c o v e r e d by trees and 4 6 m i l l i o n hectares are considered productive forest l a n d ( B C M O F 1994). T h e r e are t w o b r o a d forest types i n B r i t i s h C o l u m b i a , w i t h the d i v i d i n g l i n e between the Coast and the Interior r u n n i n g d o w n the m i d d l e o f the C a s c a d e range r o u g h l y parallel to the B C Coast, w i t h V a n c o u v e r Island a n d the Q u e e n Charlottes considered part o f the C o a s t a l forest r e g i o n . W h i l e both forest regions are d o m i n a t e d b y softwoods, there are considerable differences i n the c o m p o s i t i o n o f species. T a b l e 1 shows the relative c o m p o s i t i o n i n terms o f species for standing t i m b e r v o l u m e s for the different regions.  T h e C o a s t a l forest i s dominated b y western h e m l o c k , S i t k a spruce (Picea sitchensis ( B o n g . ) C a r r i e r e ) , true firs o r balsams (Abies amabilis ( D o u g l . E x L o u d . ) D o u g l . E x J . F o r b e s , AbiesproceraRehd., Abies grandis ( D o u g l . E x D . D o n ) L i n d . ) and western red cedar (Thuja plicata D o n n ex. D . D o n ) w i t h s m a l l e r stands o f D o u g l a s - f i r ; trees also tend to be larger than i n the Interior due to the m o r e temperate c l i m a t e . I n the Interior, spruces (Picea glauca (Moench) V o s s , Picea mariana ( M i l l . ) B S P , Picea engelmanni P a r r y e x . E n g e l m . ) , lodgepole pine (Pinus contorta D o u g l . E x L o u d . V a r . latifolia E n g e l m . ) and subalpine fir (Abies lasiocarpa ( H o o k . ) N u t t . ) predominate, and the trees tend to be m u c h smaller. T h e r e are substantial regional variations w i t h i n the Interior, w i t h Ponderosa p i n e (Pinus ponderosa D o u g l . E x P . & C . L a w s . ) present i n c o m m e r c i a l quantities i n the southern Interior, w h i l e the eastern part o f the Interior has c o m m e r c i a l quantities o f h e m l o c k and cedar.  Table 1. British Columbia Mature Standing Timber Volumes as of 1996 ( m i l l i o n s of c u b i c metres)  Species  Coast  Interior  Total Province  116  1,474  1,590  1,175  341  1,516  411  859  1,270  26  1,481  1,507  Douglas F i r  134  284  418  Western R e d Cedar  296  98  394  Y e l l o w Cedar  112  *  112  Red/Yellow Cedar***  261  15  276  _  29  29  10  10  6  7  Spruce** Hemlock** Balsam** Lodgepole Pine  Larch Ponderosa Pine White Pine  1  * less than .5 million cubic metres **includes various species which differ between regions ***Species are the same as above but reflect different reporting requirements for different tenures (source: Council of Forest Industries 1997)  T h e topography i s also varied. T h e C o a s t i s r u g g e d , w i t h little o r n o p u b l i c road access, w h i l e m u c h o f the Interior has substantial areas o f r o l l i n g forest accessible b y road. A g a i n , there are differences w i t h i n the Interior; the southern and eastern Interior are m o r e rugged than the northern and central Interior, and the transportation infrastructure i s not as w e l l developed.  Relative Importance of the Forest Industry T h e forest sector i n B r i t i s h C o l u m b i a c a n be b r o k e n into four parts f o l l o w i n g the Standard Industrial C l a s s i f i c a t i o n ( S I C ) used b y Statistics C a n a d a . T h e first t w o parts, Logging Industry ( S I C 0 4 ) a n d Forestry Services ( S I C 05), are concerned w i t h t i m b e r harvesting and management. T h e r e m a i n i n g t w o parts c o n c e r n the users o f the l o g s generated: Wood Industries, w h i c h consists o f what are c a l l e d s o l i d w o o d producers w h o manufacture s u c h goods as l u m b e r , p l y w o o d , shakes a n d shingles, p o l e s and posts, a n d remanufactured products ( S I C 25); and the Paper and Allied Industries, p r o d u c i n g m a i n l y m a r k e t p u l p , n e w s p r i n t , g r o u n d w o o d papers and other paper a n d paperboard products ( S I C 27). I n terms o f the value o f shipments, the forest sector accounted for 5 7 . 4 % o f a l l manufacturing shipments i n B C i n 1995, exports o f l u m b e r were $7.5 b i l l i o n , and exports o f a l l p u l p and paper products were $8.2 b i l l i o n ( C O F I 1996).  P u l p and paper m i l l s i n the p r o v i n c e receive most o f their fibre needs i n d i r e c t l y f r o m the s o l i d w o o d sector i n the f o r m o f residual w o o d c h i p s p r o d u c e d d u r i n g manufacturing; w h e n these are taken into account fibre c o n s u m p t i o n between the t w o major industries, w o o d and p u l p and paper, was nearly equal i n v o l u m e . I n value-added terms, newsprint and p u l p accounted for, o n average, 2 8 % o f the value-added i n the forestry sector for the p e r i o d 1983 to 1993, w h i l e l u m b e r and p l y w o o d accounted for 3 7 % ( S c h w i n d t a n d H e a p s 1996).  T h e r e is some significant v a r i a t i o n i n the p u l p and paper industry between the t w o regions, reflecting differences i n the resource base and the development o f markets. F o r e x a m p l e ,  the a v a i l a b i l i t y o f western h e m l o c k and its suitability for newsprint, c o u p l e d w i t h the tidewater l o c a t i o n o f Coastal p u l p and paper m i l l s has l e d to the development o f more newsprint and other g r o u n d w o o d paper capacity relative to the Interior. I n addition, the s p e c i a l i z e d l u m b e r production o f different species (such as cedar and D o u g l a s fir) o n the Coast has permitted the development o f specialty pulps to a larger degree than i n the Interior, where most l u m b e r p r o d u c t i o n i s S P F ( S p r u c e - P i n e - F i r ) w i t h the resulting c h i p s a b l e n d o f different species.  Interior p u l p and paper m i l l s have also been nearly completely reliant o n residual chips produced i n the Interior, w h i l e C o a s t a l m i l l s have had to r e l y increasingly o n a variety o f sources i n c l u d i n g i m p o r t e d c h i p s , chips f r o m the Interior, and c h i p s p r o d u c e d f r o m r o u n d w o o d . G o v e r n m e n t p o l i c y , i n c l u d i n g h o w stumpage charges are c a l c u l a t e d , also differs between the t w o regions, i n terms o f what types o f p u l p fibre are i n c l u d e d i n the appraisal system and what type o f harvested material i s required to be brought i n .  In the past, nearly a l l o f the w o o d chips produced and c o n s u m e d i n the Interior have been residual chips p r o d u c e d b y s a w m i l l s , although there has been an i n c r e a s i n g use o f r o u n d w o o d c h i p s i n recent years.  T h e alternative for Interior s a w m i l l s to s h i p p i n g w o o d chips to p u l p and paper m i l l s i n the Interior is either to b u r n t h e m or to put t h e m into landfills, both c o m m o n practices i n the past. I n most cases, chips were burnt a l o n g w i t h other residue i n " b e e h i v e burners". E n v i r o n m e n t a l considerations have caused a rapid escalation i n the costs associated w i t h l a n d f i l l i n g , and the p r o v i n c i a l government is i n the process o f p r o h i b i t i n g the b u r n i n g o f w o o d waste throughout the r e g i o n .  Patterns of Resource Use in BC Before investigating the development o f the w o o d c h i p market, it i s instructive to l o o k at the patterns o f p r o d u c t i o n a n d use o f w o o d fibre i n B r i t i s h C o l u m b i a .  Figure  1 shows  timber p r o d u c t i o n i n B C o n the C o a s t and i n the Interior for selected years since 1950. It c a n be seen that w h i l e the harvest steadily increased i n both areas, p e a k i n g o n the C o a s t i n 1987 and i n the Interior i n 1989, the o v e r a l l increase i n harvest l e v e l s has c o m e m a i n l y f r o m the Interior. W h i l e harvest levels r o u g h l y d o u b l e d o n the Coast, they increased tenf o l d i n the Interior f r o m 1950 to 1995.  Figure 1 . Harvest by Region in BC for Selected Years 100  1950  1965  1973  1977 1980 D Coast  1983 1986  1989 1992 1995  El Interior  (Source: Ministry of Forests, various years)  T h i s increase i n timber production was a c c o m p a n i e d by an increase i n p u l p a n d paper production.  Table 2 shows  the p r o d u c t i o n o f pulp ( w h i c h m a y be further c o n v e r t e d into  paper or s o l d as pulp) and l u m b e r i n the p r o v i n c e over the past twenty five years. T h e p r o d u c t i o n o f both has steadily g r o w n , w i t h p u l p p r o d u c t i o n p e a k i n g i n 1994, seven years after the peak i n l u m b e r production.  Table 2 . Lumber and Pulp Production in BC Year  L u m b e r (in MMbf)  P u l p (in thousands of tonnes)  1960  5,305  1,754  1970  7,657  3,731  1975  7,445  3,808  1980  11,351  5,456  1987  15,886  6,990  1990  14,198  6,604  1991  13,308  6,702  1992  14,141  6,646  1993  14,381  7,048  1994  14,269  7,617  1995  13,819  7,608  1996  13,845  7,287  1997  13,375  7,099  1998  12,814  7,073  (Source: 1960-75 Canadian Forestry Service, 1980-85 Statistics Canada 25-201 various years, CPPA Reference Tables, various years 1987-1998 Council of Forest Industries BC Statistical Tables, various years)  Table 3 shows the p r o d u c t i o n o f residual w o o d chips b y r e g i o n f o r the past ten years. D u e to the nature o f the p r o d u c t i o n process, residual c h i p p r o d u c t i o n shows the same pattern as l u m b e r p r o d u c t i o n , p e a k i n g i n 1987. W h i l e o v e r a l l residual c h i p p r o d u c t i o n levels have subsequently fallen, it can be seen that is m a i n l y due to a decrease i n residual c h i p p r o d u c t i o n o n the Coast, w h i l e Interior residual c h i p p r o d u c t i o n has r e m a i n e d relatively steady.  Table 4 shows the export o f w o o d c h i p s f r o m the p r o v i n c e , identified b y their r e g i o n o f o r i g i n , o v e r the study p e r i o d . E x p o r t s f r o m the Interior have ranged around 1 0 % o f total p r o d u c t i o n f o r the past decade, a n d i n c l u d e exports b y F i b r e c o E x p o r t (an export agency for s a w m i l l s i n the Interior), i n d i v i d u a l s a w m i l l s , and p u l p c o m p a n i e s w i t h i n the r e g i o n . W h i l e exports f r o m the Interior have f a l l e n i n recent years, an increasing proportion o f shipments to F i b r e c o E x p o r t have been purchased b y p u l p m i l l s o n the B C Coast.  Table 3. Residual Chip Production in B C , by Region (in 000's of BDUs) Year  Coast  Interior  1985  2,964  5,706  1986  2,796  5,667  1987  3,475  6,685  1988  3,741  6,700  1989  3,250  6,770  1990  2,770  5,832  1991  2,681  6,290  1992  2,582  6,479  1993  2,494  6,341  1994  2,594  6,221  1995  2,340  6,336  1996  2,262  5,979  1997  2,078  5,907  1998  1,835  5,576  (Source: Statistics Canada 35-001, various years)  Table 4 . Exports of Wood Chips from B C by Region for Selected Years (BDUs) Year  Coast  Interior  1987  310,301  577,420  1991  487,598  914,944  1992  385,751  943,476  1993  233,855  842,437  1994  154,509  483,009  1995  107,611  353,251  (Source: unpublished data, Ministry of Forests)  Increased p u l p i n g capacity throughout B C has l e d to the g r o w i n g use o f r o u n d w o o d c h i p s , w i t h most o f p r o d u c t i o n and c o n s u m p t i o n t a k i n g place o n the Coast. A l t h o u g h p r o d u c t i o n statistics do not separate r o u n d w o o d f r o m residual c h i p p r o d u c t i o n , there are s u m m a r y statistics available that p r o v i d e some i n d i c a t i o n o f the amount o f r o u n d w o o d c h i p s b e i n g  produced.  Table 5 shows estimates o f the fibre passing through p u l p m i l l w o o d  r o o m s and c h i p p i n g m i l l s o v e r the past f i v e years versus that g o i n g to other p r i m a r y producers ( w h o m a y also produce r o u n d w o o d c h i p s ) . It c a n be seen that w h i l e the amount o f l u m b e r processed at s a w m i l l s fell slightly, the largest increase was i n the amount o f r o u n d w o o d passing t h r o u g h c h i p p i n g m i l l s . T h i s has reflected both a m o v e into poorer quality stands, y i e l d i n g a greater p r o p o r t i o n o f w o o d suitable f o r c h i p p i n g , and the need to supplement d e c l i n i n g quantities o f residual w o o d chips.  Table 5. Estimates of the Primary Breakdown of Harvest in B C from 1990 to 1996 (in thousands of cubic metres)  1990  1991  1992  1993  1994  1995  64,129  58,128  60,849  61,472  60,098  59,576  58,841  -8%  Chip Mill  1,647  2,237  2,468  3,098  4,155  4,237  3,454  110%  Pulp Mill  3,605  7,600  3,349  3,851  2,841  3,815  3,769  5%  Veneer/Panel  4,406  4,450  4,713  4,642  5,413  5,435  5,103  16%  Shake/Shingle  1,711  1,539  1,321  1,223  1,173  1,291  1,437  -16%  Pole/Post/Log  372  521  530  476  479  582  528  42%  Export  804  768  1,139  1,170  735  612  312  -61%  Reject  197  596  447  Sawmill  :  1996  Total  76,477  75,297  74,369  75,932  74,894  74,952  73,891  Actual Harvest  78,316  73,676  74,004  75,392  75,650  76,741  75,213  % change  (Source: Economics and Trade, Ministry of Forests, unpublished data derived from Major Primary Timber Processors)  H a r v e s t l e v e l s f r o m p r o v i n c i a l lands peaked i n the late 1980s (see Figure 1) a n d a series o f government initiatives c o u l d m e a n that harvest l e v e l s m i g h t fall 1 7 % i n the future, w i t h some areas f a c i n g even greater reductions (Price W a t e r h o u s e 1995). C o n s e q u e n t l y , both l u m b e r a n d w o o d c h i p p r o d u c t i o n l e v e l s are expected to drop i n the near future.  Sawmills  w i t h i n the Interior have i n c r e a s i n g l y turned to i m p o r t i n g w o o d fibre f r o m A l b e r t a a n d other provinces a n d increased purchases o f w o o d f r o m private lands w i t h i n the p r o v i n c e to meet their fibre needs d u r i n g periods o f h i g h d e m a n d .  14  F i g u r e 1 .2 I n t e r i o r F o r e s t P r o d u c t P r i c e s Adjusted f o r Inflation 1 9 7 0 - 9 6 $1,200 $1,000 $800  e e  $600 $400 $200 $0 1970  1 974  1978  1982  1986  1990  1994  NBSK Pulp (Dfltd)  - • — SPF Lumber (Dfltd)|  SPF Stud (Dfltd)  - a t — Chips (Dfltd)  (Source: All prices 1970-92 Canadian Forestry Service; lumber prices 1993-96 Madison's various issues, pulp prices Pulp & Paper Factbook, various years, chip prices derived from various sources throughout the text)  S i m o n s and C o r t e x (1993) e x a m i n e d the h i s t o r i c a l prices o f l u m b e r and chips i n B r i t i s h C o l u m b i a . T h e y reported that c h i p prices o n the C o a s t s h o w e d a d o w n w a r d trend o f 2% per year i n real terms f r o m 1970 to 1993, w h i l e interior c h i p prices had not changed significantly i n real terms for the same time period, expressed as a percentage o f the p u l p price.  Figure 2 shows  prices f o r b o t h l u m b e r , p u l p , and interior w o o d c h i p s i n real terms  for the p e r i o d 1970-96. A s c a n be seen, p u l p a n d l u m b e r prices have s h o w n strong c y c l i c a l behavior over this period, w h i l e the price o f interior chips has c l o s e l y tracked p u l p prices u n t i l 1995 w h e n both p u l p and c h i p prices reached record l e v e l s , o n l y to f a l l i n 1996. T h e prices reported are f o r N B S K p u l p ( N e e d l e B l e a c h e d S o f t w o o d K r a f t p u l p , S P F studs ( 2 x 4 l u m b e r i n 8 foot lengths) a n d S P F l u m b e r ( 2 x 4 l u m b e r i n r a n d o m  lengths), a l o n g w i t h the price for Interior w o o d chips, and have a l l been deflated u s i n g the G D P deflator.  Structure  of the BC Interior  Wood  Chip  Market  In 1996 there were 136 s a w m i l l s i n the Interior w i t h an annual capacity i n excess o f 2 m i l l i o n board feet.  3  O f these, 9 4 h a d an annual capacity o f over 2 4 m i l l i o n board feet per  year. T h o s e 9 4 accounted for 9 7 % o f the total Interior l u m b e r capacity o f 11 b i l l i o n board feet (as o f 1996). A p p r o x i m a t e l y 5 1 % o f this capacity i s o w n e d by independent s a w m i l l s (that i s , unaffiliated w i t h a c o m p a n y p r o d u c i n g p u l p and paper). ' 4  5  A l t h o u g h regional  rights to timber differ, integrated companies control slightly m o r e than h a l f o f the assigned cutting rights to C r o w n timber. T a b l e 6 shows the top twenty C r o w n t i m b e r l i c e n s e holders i n the p r o v i n c e , w i t h companies possessing p u l p a n d paper processing capacity s h o w n i n b o l d type.  There are currently 2 5 p u l p m i l l s i n the p r o v i n c e .  6  Fourteen o f the p u l p m i l l s are located i n  the Interior, w i t h t w o , S k e e n a K r a f t and E u r o c a n , o n the N o r t h C o a s t and nine o n the B C C o a s t . W i t h the e x c e p t i o n o f t w o , C e l g a r and H a r m a c P a c i f i c , these p u l p m i l l s are o w n e d 7  b y companies that have either received cutting rights through s a w m i l l s o w n e d or affiliated w i t h the c o m p a n y or have received cutting rights d i r e c t l y .  8  3  There are no reliable numbers o n sawmills smaller than this. A s a measure o f comparison, there are 88 sawmills o n the B C Coast with an aggregate capacity o f 4.3 b i l l i o n board feet.  4  Slocan accounts for 10% o f this capacity and is included as an independent, although they o w n nearly all o f the pulp m i l l at T a y l o r . T h e y had acquired half ownership o f one o f the pulp m i l l s and sawmills at M a c k e n z i e w h i c h they have subsequently sold to the other partner. T h e i r s a w m i l l i n g operations are w i d e l y distributed throughout the province and the bulk of their sales are made to non-affiliated pulp m i l l s .  5  These figures were derived from Major Primary Timber Processing Facilities in British Columbia 1995 issued b y the B C M i n i s t r y o f Forests.  6  T h e pulp m i l l at G o l d R i v e r was closed i n 1998 and efforts to re-open it have so far failed.  7  B o t h Skeena and E u r o c a n rely for a substantial portion o f their p u l p fibre needs on residual w o o d chips from the Interior and consequently are considered part o f the Interior market.  8  Celgar filed for bankruptcy i n July, 1998, while Harmac was acquired b y Pope & Talbot, a company w i t h sawmills i n the Southern Interior, i n December 1997. In addition, M a c M i l l a n Bloedel spun off its two remaining pulp mills on the B C Coast i n June, 1998, but retains obligations to supply fibre to those m i l l s . 16  Table 6. Annual Public Cutting Rights in B C in 1997 by Company (in cubic metres)* Company  Slocan Forest Products MacMillan Bloedel" Canadian Forest Products West Fraser Mills International Forest Products'  1  Noranda Forest Inc. Doman Industries Skeena Cellulose R i v e r s i d e Forest Products'  1  Weldwood Weyerhaeuser Avenor Tolko T i m b e r w e s t Forest* Anderson/Stewart Group Ainsworth Lumber  Crestbrook Forest Industries Pope & Talbot  Louisiana-Pacific Canada E v a n s Forest Products Allowable Annual Cut ( A A C ) A A C Held by Companies with P u l p and P a p e r Interest  0  License Volumes 6,797,383 5,917,561 4,810,040 4,204,134 3,514,152 3,441,398 2,427,140 2,337,549 2,306,776 2,099,109 1,672,813 1,658,558 1,547,914 1,445,280 1,387,740 1,349,034 1,220,095  3  % of A A C  1,175,137 904,000 630,898 70,864,250 38,935,060  9.6 8.4 6.8 5.9 5.0 4.9 3.4 3.3 3.3 3.0 2.4 2.3 2.2 2.0 2.0 1.9 1.7 1.7 1.3 0.9  C u m u l a t i v e Percent 9.6 17.9 24.7 30.7 35.6 40.5 43.9 47.2 50.5 53.4 55.8 58.1 60.3 62.3 64.3 66.2 67.9 69.6 70.9 71.8  54.9% of A A C  "These volumes are as of July 22, 1997, and do not include any private timberlands which provide significant volumes to several companies. The company has spun off of all of its pulp and paper mills but still retains fibre obligations to them. Canadian Forest Products holds 1/3 interest in the Anderson/Stewart group that is not included in this volume. These firms have evergreen contracts dedicating significant portions of their pulp fibre production to pulp 0  d  companies (see Gaston et al 1995 for more information). The cutting rights are not included in the calculation of the AAC held by pulp and paper companies. •When the parent company (Fletcher Challenge Canada) de-integrated it retained the right to all pulp fibre produced by Timberwest and hence these volumes are included in the pulp and paper AAC. Source: Economics and Trade, Ministry of Forests, Licensee's Annual Commitments, July 22,1997.  A l l o f these p u l p m i l l s , w i t h the exception o f the L o u i s i a n a P a c i f i c p u l p m i l l i n C h e t w y n d , the Scott P a p e r m i l l i n N e w W e s t m i n s t e r , a n d the N e w s t e c h m i l l i n Port C o q u i t l a m , use coniferous chips as either the m a i n p o r t i o n o f their furnish or as their c o m p l e t e source. I n 1995, independent s a w m i l l s i n the Interior p r o v i d e d 4 2 % o f the residual w o o d chips c o n s u m e d by Interior p u l p m i l l s (although there was substantial r e g i o n a l v a r i a t i o n ) . 9  9  T h i s figure is based o n background data from N e l s o n (1997).  Concentration w i t h i n regional fibre markets is quite h i g h (these regional markets correspond to the s i x forest regions the p r o v i n c e uses i n m a n a g i n g p r o v i n c i a l forests). T h r o u g h o u t m u c h o f the Southern Interior (the K a m l o o p s and N e l s o n Forest R e g i o n s ) , one p u l p m i l l w i l l purchase the majority o f the fibre p r o d u c e d w i t h i n the r e g i o n . W h i l e s m a l l v o l u m e s o f chips m a y be exported, shipments are capped and require government a p p r o v a l every f e w years. W i t h i n the K a m l o o p s area, the p r o x i m i t y o f the C o a s t and h i g h e r production levels relative to the capacity o f the Weyerhaeuser p u l p m i l l m e a n that significant v o l u m e s o f chips are shipped into the C o a s t a l market ( G a s t o n et a l . 1995). I n the N o r t h e r n Interior (100 M i l e H o u s e and the area to the north), the closer p r o x i m i t y o f p u l p m i l l s to one another u s u a l l y means t w o or m o r e purchasers w i t h i n l o c a l markets. D e s p i t e this p r o x i m i t y , s a w m i l l s i n the past tended to sell to o n l y one purchaser.  Most  exports f r o m the Interior were m a d e through a cooperative o w n e d b y s a w m i l l s throughout the Interior c a l l e d F i b r e c o E x p o r t . T h e cooperative p l a c e d various constraints o n the p r i c e members c o u l d receive and the v o l u m e s that c o u l d be shipped ( F i b r e c o E x p o r t is discussed later i n this chapter). F i b r e c o export v o l u m e s are also subject to o v e r a l l restrictions and the need to o b t a i n government a p p r o v a l for exports every few years.  Pulping  Processes  B r o a d l y s p e a k i n g , there are t w o m a i n w a y s to produce p u l p f r o m w o o d f i b r e . O n e is through strictly m e c h a n i c a l means to separate the w o o d fibres (sometimes termed refiner pulp) and the other is through c h e m i c a l processes such as sulfite p u l p i n g o r sulfate p u l p i n g (referring to the predominant c h e m i c a l present d u r i n g p u l p i n g ) . I n a d d i t i o n , recent years h a v e seen the development o f some h y b r i d processes such as chemi-thermomechanical p u l p ( C T M P ) that use both m e c h a n i c a l and c h e m i c a l processes. T h e fibre requirements differ for the v a r y i n g processes. M e c h a n i c a l pulps require naturally bright w o o d s , western h e m l o c k and spruce b e i n g the preferred species. W h i l e kraft p u l p i n g c a n accommodate a greater variety o f species than m e c h a n i c a l p u l p i n g , bright w o o d s are also desirable as they reduce the need for c h e m i c a l b l e a c h i n g . T h e major difference between the t w o processes,  h o w e v e r , is that m e c h a n i c a l processes require r o u g h l y h a l f the fibre per unit o f output compared to the kraft process although the energy requirements are substantially higher.  M o s t o f the p u l p m i l l s i n the Interior use the bleached kraft process w h i l e the m i l l s b u i l t since 1980 at Q u e s n e l , T a y l o r , and C h e t w y n d r e l y o n either the thermo-mechanical ( T M P ) or the c h e m i - t h e r m o m e c h a n i c a l p u l p ( C T M P ) process. T h e most recent m i l l b u i l t , L o u i s i a n a P a c i f i c i n C h e t w y n d , uses aspen, w h i l e the T a y l o r m i l l has the capacity to use aspen.  S o m e sawdust p u l p capacity exists at both the K a m l o o p s a n d K i t i m a t m i l l s , w h i l e Fletcher C h a l l e n g e has recently installed a sawdust digester at its M a c k e n z i e m i l l . T h e b u l k o f the capacity i s i n c h e m i c a l p u l p u s i n g residual softwood chips. F i g u r e 3 shows the l o c a t i o n o f p u l p and paper m i l l s i n the Interior and the extent o f what is c o m m o n l y c a l l e d the Interior market. T a b l e 7 shows the development o f p u l p i n g capacity i n the Interior o v e r the p e r i o d 1988-1998 as w e l l as the type o f capacity. C a p a c i t y has remained relatively unchanged over this time frame, w i t h the e x c e p t i o n o f the expansion o f the C e l g a r m i l l i n the southeast corner o f the p r o v i n c e .  T h e p u l p a n d paper industry i n B C produces m a i n l y p u l p a n d newsprint, w i t h some specialty g r o u n d w o o d papers. I n the Interior, w i t h the e x c e p t i o n o f the F i n l a y m i l l , w h i c h produces newsprint e x c l u s i v e l y , and P r i n c e G e o r g e P u l p & P a p e r w h i c h a l o n g w i t h E u r o c a n produces sack kraft and linerboard, the m a i n product for the r e m a i n i n g p u l p and  19  Figure 3. Location of Pulp Mills in the BC Interior  Note: Locations are approximate and the map does not show any of the pulp mills in the Vancouver Forest Region  20  paper m i l l s i s market p u l p ( L o c k w o o d Post d i r e c t o r y , 1995). M a r k e t p u l p i s 10  defined as p u l p sold i n a r m s ' length transactions between non-affiliated companies (as opposed to p u l p c o n s u m e d b y a paper m i l l affiliated w i t h the p u l p m i l l ) . W h i l e B C has 27% of the C a n a d i a n p u l p and paper capacity, slightly b e h i n d Q u e b e c w i t h 31%, B C i s the largest producer o f market p u l p i n C a n a d a w i t h 49.4% o f the C a n a d i a n market p u l p capacity. C a n a d a itself is the largest producer o f market p u l p i n the w o r l d a n d has 27% o f w o r l d c a p a c i t y ( A n o n y m o u s , 1994).  T a b l e 7. Interior Pulp Capacity by M i l l and Location, Selected Years Mill Location Weyerhaeuser Kamloops Castlegar Celgar Skookumchuck Crestbrook Total Southern Interior Capacity  1988 426 193 185  1990 431 183 181  1993 440 414 181  1995 431 396 219  1998 447 414 224  804  795  1,035  1,046  1,085  Quesnel Quesnel Prince George Prince George Prince George Mackenzie Mackenzie Taylor Chetwynd Prince Rupert Kitimat  300 276 235 270 502 207 138 207  311 276 236 274 569 207 138 180  -  -  431 374  483 409  328 328 236 276 500 207 138 177 155 466 355  302 311 258 273 518 207 180 212 155 449 452  314 323 (c) 528 518 207 190 231 173 449 455  Total Northern Interior Capacity  2,940  3,083  2,930  3,057  3,388  Total Interior Capacity  3,744  3,878  3,965  4,103  4,473  Quesnel R i v e r P u l p Cariboo Intercontinental P G Pulp & Paper Northwood Fletcher Finlay Fibreco Louisiana P a c i f i c Skeena C e l l u l o s e Eurocan 3  3  3 b  8  CTMP/TMP process mill using 100% hardwood mill capacity included in PG.Pulp & Paper capacity . (Source: Economics and Trade, Ministry of Forests, Victoria unpublished data)  a  b c  In s u m m a r y , the Interior w o o d c h i p market has been f a i r l y stable i n terms o f p r o d u c t i o n l e v e l s and regional d e m a n d (as measured b y capacity). C o n c e n t r a t i o n tends to be h i g h because markets f o r chips are geographically constrained and there i s o n l y a s m a l l n u m b e r o f purchasers (often o n l y one) w i t h i n most l o c a l markets. I n order to sell into the export  10  A c c o r d i n g to the C P P A (1996), total industry capacity i n B C for market pulp, paper, and paperboard was 8.3 m i l l i o n tonnes, o f w h i c h 5.2 m i l l i o n tonnes were i n market pulp, or 6 3 % o f the total.  21  market, p r o v i n c i a l government approval is required a n d v o l u m e s tend to be s m a l l and o f l i m i t e d duration. T h e s i m i l a r i t y o f end products a n d prevalence o f the same species means that most o f the w o o d c h i p s produced w i t h i n the Interior are potentially interchangeable, and f i r m s i n the r e g i o n d o engage i n c h i p swaps (trading fibre f r o m different suppliers to either meet species requirements o r to reduce transportation costs). H o w e v e r , i n the past, m o s t s a w m i l l s s u p p l i e d o n l y one p u l p m i l l , a n d these s u p p l y patterns had remained relatively unchanged since the development o f the Interior market i n the 1950s ( N e l s o n et a l . 1994). T h i s pattern c h a n g e d i n 1994, and to understand w h y , i t i s necessary to e x a m i n e the development o f the Interior market.  Historical  Development  of the Interior  Pulp  Industry  T h e development o f the p u l p a n d paper industry i n the B C Interior reflects the p r o v i n c i a l government's traditional approach to forest p o l i c y based o n the allocation o f tenure a n d fibre to encourage industrial d e v e l o p m e n t outside the l o w e r m a i n l a n d area. H o w e v e r , as part o f this strategy, the P r o v i n c e has also h a d to address concerns o v e r market p o w e r a n d fibre s u p p l y . T h i s section w i l l show h o w both the market a n d government p o l i c y have e v o l v e d i n some unexpected ways.  I n i t i a l l y , the market for Interior w o o d c h i p s was l i m i t e d to s m a l l shipments to p u l p m i l l s outside the r e g i o n . S a w m i l l s i n the Interior after W o r l d W a r II tended to be s m a l l , and most o f the w o o d fibre p r o d u c e d w a s i n the f o r m o f slabs a n d l i l y pads ( l i l y pads were the d i s k s o f w o o d s l i c e d o f f the ends o f l o g s ) . A n y residual c h i p s p r o d u c e d were either burned o r put into l a n d f i l l s a l o n g w i t h other waste w o o d , a l t h o u g h there w e r e some shipments o f c h i p s f r o m those s a w m i l l s i n the southern Interior nearest to C o a s t a l p u l p m i l l s . D u e to concerns about the amount o f waste left b e h i n d (some estimates suggested that 7 5 % o f the tree was left b e h i n d i n the w o o d s ) ( G a r n e r 1991), the government c o m m i s s i o n e d a study i n the early 1960s to e x a m i n e the feasibility o f a p u l p m i l l i n the P r i n c e G e o r g e area to u t i l i z e the m a r g i n a l w o o d left b e h i n d . T h e findings o f the report  22  l e d R a y W i l l i s t o n , then M i n i s t e r o f Forests, to d e v e l o p a set o f p o l i c i e s to encourage c o m p a n i e s to establish p u l p and paper m i l l s i n the Interior ( G a r n e r 1991).  The Development  of Pulpwood  Harvesting  Agreements  G i v e n the concerns o v e r the size o f the capital investment required to construct a w o r l d - c o m p e t i t i v e p u l p m i l l (approximately $ 5 0 m i l l i o n i n the early 1960s), W i l l i s t o n offered the guarantee that m i l l s built w o u l d have an assured fibre supply through a n e w type o f forest tenure c a l l e d P u l p w o o d H a r v e s t i n g A g r e e m e n t s ( P H A ) . T h e s e were i n t r o d u c e d under amendments to the Forest A c t i n 1961 ( B r i t i s h C o l u m b i a 1961), a n d w e r e o r i g i n a l l y restricted to the I n t e r i o r .  11  A l t h o u g h this  p r o v i s i o n w a s later d r o p p e d for several years, there w e r e never any P H A s i s s u e d f o r the C o a s t . T h e P H A s were f o r 21 years a n d required the successful applicant to b u i l d a n d operate a p u l p m i l l o f a specified capacity. T h e agreements specified a certain area and a m a x i m u m v o l u m e that c o u l d be harvested, a n d required the p u l p m i l l s to purchase p u l p w o o d a n d w o o d residues f r o m t i m b e r cut w i t h i n the p u l p w o o d area b y e x i s t i n g tenure (quota) holders before they c o u l d u t i l i z e the agreement.  12  T h o s e purchases were c o n d i t i o n a l o n the prices f o r the residue not e x c e e d i n g the  costs o f harvesting p u l p w o o d f o r the p u l p m i l l . I f the p u l p m i l l w a s unable to purchase e n o u g h fibre at that price, the agreement c o n v e y e d the right to cut p u l p w o o d directly to m a k e up any d e f i c i e n c y . T h e first p u l p w o o d agreement was a w a r d e d to P r i n c e G e o r g e P u l p & P a p e r i n 1963, f o l l o w e d b y one to K a m l o o p s P u l p a n d P a p e r i n 1963, then N o r t h w o o d P u l p & P a p e r i n 1964, C a r i b o o P u l p a n d P a p e r i n 1965, a n d another one to P r i n c e G e o r g e P u l p & P a p e r i n 1 9 6 5 .  13  11  Section 1 7 A , Forest A c t o f 1978 (British C o l u m b i a 1978).  12  Clause number seven appears to have been related to the issue o f the potential conflict between sawmills and pulp mills for cutting rights. Pearse, a chairman o f a R o y a l C o m m i s s i o n , queries Prince George P u l p o n this: [Pearse]: " N o w , m y understanding is that originally, i n 1962, the pulp company was prohibited from competing for saw timber sales i n the P . H . A . area without the consent o f the M i n i s t e r . " [Gunther]: " Y e s , that was a condition i n clause 7,1 believe, o f the original P . H . A . agreement."(Pearse 1976a: 701)  In P . H . A . no. 2, clause 7 b required the p u l p m i l l to purchase p u l p w o o d generated i n the course o f harvesting a stand i f offered to the company before they c o u l d utilize the agreement. H o w e v e r , these clauses as they relate to p u l p w o o d appear to have been modified or dropped entirely subsequently [this clause as it related to P . H . A . 1 was dropped i n 1972 when the commitment to purchase residual chips was incorporated](Pearse 1976a: 701)  23  H o w e v e r , not a l l the p u l p m i l l s b u i l t i n the Interior received P H A s . T h e first m i l l established i n the Interior was C o l u m b i a C e l l u l o s e (now C e l g a r ) at Castlegar i n the Southern Interior i n 1961, w h i c h received its cutting rights through an adjacent s a w m i l l i n the f o r m o f a T r e e F a r m L i c e n s e ( T F L ) . T h e t w o p u l p and paper m i l l s o n the N o r t h C o a s t (considered part o f the Interior market) also received cutting rights through T F L s .  S k e e n a C e l l u l o s e opened a second K r a f t p u l p m i l l i n  1967 i n P r i n c e Rupert. T h e o r i g i n a l owner, C o l u m b i a C e l l u l o s e , had opened a sulfite p u l p m i l l there i n 1951 w h i c h was later converted to K r a f t i n 1980. E u r o c a n opened a p u l p m i l l i n 1970 at K i t i m a t (a j o i n t partnership between W e s t Fraser and a F i n n i s h c o m p a n y , E n s o - G u t h e i z t ) .  14  C r e s t b r o o k Forest Industries also built a p u l p m i l l i n 1969 at S k o o k u m c h u c k , i n the Southeast corner o f the p r o v i n c e , but d i d not receive a P H A . C r e s t b r o o k r e c e i v e d an assured supply o f fibre through their m i l l license w h i c h directed s a w m i l l s i n the area to send them their residual chips (this is discussed m o r e fully i n the section entitled Introduction of Chip Direction Policy).  15  T h e other  exceptions have been the t w o integrated s a w m i l l and p u l p m i l l operations at M a c k e n z i e , each o f w h i c h r e c e i v e d harvesting rights for the s a w m i l l s and were envisaged as stand alone operations.  M a n y o f the companies that built p u l p m i l l s i n the Interior such as N o r t h w o o d , W e l d w o o d , and W e s t Fraser h a d p r e - e x i s t i n g s a w m i l l s i n the area. Others were j o i n t ventures between l o c a l s a w m i l l s and outside interests, s u c h as K a m l o o p s P u l p and Paper (subsequently acquired b y Weyerhaeuser) and Crestbrook, w h i l e C a n a d i a n Forest Products b u i l t a s a w m i l l at P r i n c e G e o r g e after r e c e i v i n g its P H A . T h i s ensured that a p o r t i o n o f their supply was m e t b y w o o d c h i p s f r o m their o w n facilities.  A t the same time the B C government h a d been studying the feasibility o f establishing p u l p m i l l s i n the Interior, a n e w type o f s a w m i l l c a l l e d the C h i p N ' S a w h a d been d e v e l o p e d ( K e a y s , 1 9 7 9 ) .  13  Several other P H A s were awarded but the pulp mills were never built and the agreements lapsed.  14  Celgar received T F L 23, w h i c h was the only Interior T F L issued appurtenant to a pulp m i l l . O n the N o r t h Coast, Eurocan received T F L 41 i n 1966, while the two pulp mills i n Prince Rupert had two T F L s (nos. 1 and 40), each dating from the establishment o f a pulp line. T F L 1 contains an appurtenancy clause requiring the licensee to operate a pulp m i l l (Haley i n litt. 1995).  15  M i l l licenses were required i n the past by companies planning to b u i l d or expand timberprocessing capacity.  24  P r e v a i l i n g designs at the t i m e b r o k e d o w n l o g s b y s a w i n g o f f the sides, l e a v i n g b e h i n d slabs and various other pieces o f irregularly s i z e d s o l i d w o o d w h i c h c o u l d then be fed into a chipper to be converted into w o o d c h i p s . T h e C h i p N ' S a w , h o w e v e r , c h i p p e d o f f the l o g faces w h i l e h o l d i n g the l o g m o r e f i r m l y . T h i s permitted smaller l o g s to be processed more q u i c k l y . S m a l l e r l o g s had presented a p r o b l e m w i t h the older d e s i g n as they tended to wander w h e n b e i n g sawed and s l o w e d d o w n p r o d u c t i o n . B e c a u s e m o r e o f the standing t i m b e r c o u l d n o w be u t i l i z e d , it n o w p a i d to sort logs and to r u n batches o f s i m i l a r sizes through the C h i p N ' S a w . T h i s also r e d u c e d the need to change the s a w i n g setup to accommodate variations i n l o g size required w i t h the older designs. A s a consequence, the throughput o f l o g s c o u l d be increased s i g n i f i c a n t l y , thereby r a i s i n g l u m b e r and c h i p p r o d u c t i o n .  The  Move  to Close  1 6  Utilization  Standards  T h e B C government also undertook some specific p o l i c i e s affecting the supply o f timber w i t h i n the Interior. T h i s i n v o l v e d a change f r o m an intermediate utilization standard to a "close u t i l i z a t i o n " c  standard i n the m i d - 1 9 6 0 s . T h i s standard required companies to harvest s m a l l e r trees than i n the past (as w e l l as t a k i n g m o r e o f the tree).  Operators c o u l d receive additional timber rights (or  17  quota) by demonstrating that they had the equipment to process smaller t i m b e r and c o u l d produce chips to sell to a p u l p m i l l . B e c a u s e the increase i n harvest levels by adapting close u t i l i z a t i o n standards c o u l d not be fully absorbed by a l l the s a w m i l l s at the t i m e , the additional unallocated w o o d w a s k n o w n as " t h i r d b a n d w o o d " .  1 8  A p p l i c a n t s d i d not have to b i d for the additional quota  ' T h e r e are two reasons for the development o f the c h i p p i n g headrig [the machinery that first breaks d o w n a l o g at the sawmill]. Conventional sawmilling practice gave lumber - the primary product, plus slabs, edgings, trim and l i l y pads, w h i c h could be converted into chips, plus sawdust, for w h i c h there was no ready market. Generally the sawdust had to be disposed of, a practice w h i c h was a cost i n itself, and w h i c h ran into increasingly heavy opposition for environmental reasons. It w o u l d be of obvious economic recovery advantage to reduce the sawdust, and possibly to improve lumber recovery. Once the c h i p p i n g headrig had been developed ( i n the m i d - 1 9 6 0 ' s ) , a powerful economic incentive developed for their widespread application. T h e value o f lumber was greater per volume o f w o o d than the value o f chips, but the small logs available i n many areas could not be processed profitably by conventional s a w m i l l i n g equipment." (Keays 1979: 9-10) F o r example, the standard for trees i n the Interior went f r o m 1 1 " d.b.h. d o w n to 7 " d.b.h., w i t h utilization to a 4 " top, w h i l e m a x i m u m permissible stump heights decreased f r o m 18" to 12" (Bernsohn 1981: 84) T h e name third band came from the idea that i f y o u drew a rectangle for a l l the w o o d w i t h i n a P u b l i c Sustained Y i e l d U n i t ( P S Y U s were the administrative unit used for allocating cutting rights at  25  but rather received it through a T i m b e r Sale H a r v e s t i n g L i c e n s e ( T S H L ) .  1 9  B y the 1970s,  the B C government was mandating the use o f close u t i l i z a t i o n standards for a l l cutting areas. T o m a k e this smaller w o o d e v e n more attractive, the government f i x e d the rate at 5 5 cents per 100 c u b i c feet. T h i s was b e l o w the s a w l o g stumpage rate at the t i m e .  2 0  T h e a l l o c a t i o n o f this additional v o l u m e h a d several effects o n the Interior s a w m i l l industry. T h e first was the increased capital requirements for equipment such as debarkers and equipment that c o u l d process smaller timber, as w e l l as the need to obtain a c h i p contract w i t h a nearby p u l p mill.  2 1  S m a l l e r s a w m i l l operators started s e l l i n g out as they were unable to afford the required  equipment and the o v e r a l l result was a significant decline i n the number o f Interior s a w m i l l s w h i l e average capacity steadily increased. I n a d d i t i o n , c h i p revenues had n o w started to b e c o m e part o f the s a w m i l l ' s revenue, and those without buyers for residual c h i p s or the a b i l i t y to produce c h i p s f o u n d themselves at a g r o w i n g disadvantage.  T h e l u m b e r industry responded q u i c k l y as the B C government offered the p o s s i b i l i t y o f i n c r e a s i n g the amount o f t i m b e r a quota holder c o u l d cut i f they m o v e d to close u t i l i z a t i o n standards. G r o w t h was a i d e d i n part b y b o o m i n g h o u s i n g markets i n the U S .  2 2  T h e p r o d u c t i o n o f w o o d c h i p s was  the time), roughly one third o f the w o o d was currently being used at intermediate utilization standards. B y m o v i n g to close utilization standards, another third was available to the quota holders in the P S Y U w h o c o u l d process such timber. T h e remaining third o f the rectangle, or the "third band", was then the difference between that now held b y the quota holders i n the P S Y U and the increased harvest levels for the entire P S Y U c o m i n g from close utilization. (Bernsohn 1981: 8 3 85). 19  T h e forest service started issuing T S H L s i n 1967 although there was no specific legislation or amendments that spelled out this new type o f tenure. T h e y permitted firms that held cutting rights in the P S Y U to exchange their area based, shorter term cutting rights for expanded volume based cutting rights w i t h longer terms, offering greater supply security. M o s t importantly, operators were no longer required to b i d for their timber supply on an o n g o i n g basis. H o w e v e r , T S H L holders were required to operate an appurtenant facility capable of handling lumber d o w n to close utilization standards and producing w o o d chips (Haley i n litt. 1995).  2 0  These rates were set administratively and were subsequently dropped i n 1972 when the N D P government came into power (Garner 1991).  21  Rees (1966) reports that as security for a barker (a m i n i m u m o f $100,000) sawmills often had to show a c h i p contract with a pulp m i l l . Bernsohn (1981) reports that barkers and chippers cost about $215,000 at the time.  22  " O b v i o u s l y , at least a portion o f the sawmill industry is w o r k i n g toward close utilization standards m u c h sooner than V i c t o r i a , and even p u l p m i l l management, expected it w o u l d . " ( B C L 1966)  26  so great that m a n y o f the p u l p m i l l s b u i l t i n the 1960s shut d o w n their w o o d r o o m s ( t h e s e were facilities i n the p u l p m i l l that c h i p p e d p u l p l o g s ) , w h i l e some o f the later ones d i d not e v e n construct w o o d r o o m s .  2 3  A t the same time, increasing p u l p and paper capacity o n the Coast also  sent m o r e m i l l s into the Interior l o o k i n g f o r additional fibre, but h i g h transportation costs l i m i t e d the potential supply f o r m the I n t e r i o r .  24  A d a m Z i m m e r m a n , then president o f N o r t h w o o d P u l p at the t i m e , described the e v o l u t i o n o f c h i p prices i n the N o r t h e r n Interior w h e n testifying before the Pearse c o m m i s s i o n i n 1975:  ...$3.85 was the cost [in 1966] i n c l u d i n g o u r c a p i t a l a n d interest charges o f p r o d u c i n g c h i p s . . . [ i ] f one attributed n o value to the w o o d g o i n g into the product. T h e original price was started o f f at around $ 6 or $7.00, as I r e c a l l , and q u i c k l y escalated to about nine dollars and a half, and i n m y j u d g m e n t , there w a s real open c o m p e t i t i o n between the p u l p m i l l c h i p buyers...That was i n the i n i t i a l stage, and I think that was r e l a t i v e l y stable f o r perhaps a four o r f i v e year p e r i o d , at w h i c h point it began to escalate, a n d as y o u p o i n t out, there were m o r e buyers, the c o m p e t i t i o n became I guess m o r e active, although I w o u l d say equally the v o l u m e s o f chips that y o u were d e a l i n g w i t h , the numbers a l l became a lot bigger. T h e end result o f that was that i n what w o u l d be about an eight year p e r i o d , or really less than that, the c h i p p r i c e w e n t f r o m something around $7.00 to about triple that amount... P e a r s e : . . . I ' m sure that y o u w o u l d agree that i n certain places i n B r i t i s h C o l u m b i a , there are m o n o p s o m i s t i c [sic] or m o n o p o l i s t i c circumstances w h i c h w o u l d preclude truly competitive prices f r o m emerging? Z i m m e r m a n : ...I t h i n k it was a truly c o m p e t i t i v e price i n the circumstances, the circumstances b e i n g that there were i n i t i a l l y t w o buyers w h o were unrelated and i n c o m p e t i t i o n . T h e market was isolated to some extent, although the fringes — o n the fringes it was c o m p e t i t i v e . T h e W i l l i a m s L a k e area c o u l d f l o w south, and I d o n ' t remember the d o l l a r l i m i t but that put a l i m i t o n it. T h e r e was the alternative source [presumably referring to r o u n d w o o d c h i p s ] , and then there was the question o f what r e a l l y has b e c o m e a f l o o d o f chips...the s u p p l y exceeded our expectations.. (Pearse 1976: 9 6 4 , 9 6 6 - 7 )  2 3  24  C h i p p e d r o u n d w o o d fell from 341,000 B D U s ( 2 9 % o f total fibre consumed) i n 1966 to 201,000 B D U s (6.5% o f total fibre consumed) i n 1973 as residual chips used increased from 800,000 B D U s to 2.9 m i l l i o n B D U s over the same period (this excludes the N o r t h Coast)(Interior P u l p G r o u p , 1975). Coastal companies reporting that from o n e - t h i r d to three-quarters o f the cost o f an Interior c h i p was transportation and they w o u l d not pay more than price at w h i c h they could obtain Coastal chips. Reported prices i n the Interior were reported i n the winter o f 1966 to range from $ 5 to $12 per B D U at the sawmill (Rees 1966).  27  The Introduction  of Chip  Direction  Policy  T h e Interior p u l p c o m p a n i e s , w h i l e enjoying the increased p r o d u c t i o n o f residual c h i p s , became concerned over the increasing harvest c o m i n g f r o m the m o v e to a close u t i l i z a t i o n standard by the s a w m i l l s , as s a w m i l l s were n o w p r o c e s s i n g w o o d that o n l y a f e w years earlier had been c o n s i d e r e d p u l p w o o d . I n response to this c o n c e r n R a y W i l l i s t o n , the M i n i s t e r o f Forests, created the c h i p direction p o l i c y i n the m i d 1960s. It required any operator u t i l i z i n g third band w o o d to offer its chips to the nearby p u l p m i l l , w i t h the quantities based o n the amount o f fibre r e c e i v e d through the m o v e f r o m intermediate to close u t i l i z a t i o n as w e l l as the area under w h i c h it had r e c e i v e d  rights.  25  F o r the m o s t part,  c h i p direction meant that chips went to the same p u l p m i l l that h e l d the P H A i n w h i c h a s a w m i l l was located, the M i n i s t e r also required some s a w m i l l s f r o m outside P H A s to send their chips to specified p u l p m i l l s . F i n a l l y , the M i n i s t e r also stated that i f there were insufficient supplies o f fibre even after chips were directed to p u l p m i l l s , then the " t h i r d b a n d " v o l u m e w o u l d be w i t h d r a w n f r o m the s a w m i l l s and granted to the p u l p c o m p a n i e s ( C r e s t b r o o k 1976, W e y e r h a e u s e r 1976).  W h i l e Interior p u l p m i l l s f o u n d they had plentiful supplies o f chips, they still felt that the 'third-band' w o o d h a d been p r o m i s e d to t h e m through their P H A s and despite c h i p direction they had lost some control o v e r their fibre s u p p l y . O n e response was to purchase s a w m i l l s for their harvesting rights.  26  I n other words, vertical integration w a s b e i n g  encouraged.  "Canadian Forest Products agreed to use as much sawmill waste as was economically possible, and, l i k e most other Interior pulp mills, it received an understanding from the government that the firm w o u l d have the exclusive right to purchase chips from other firms i n the area covered b y the P u l p w o o d Harvesting Agreement." (Bernsohn, 1981: 98) "Consequently, timber volume that had been made available to pulp m i l l s under P H A s was now allocated to sawmills under T h i r d B a n d T i m b e r Sales...Although by-product chips largely replaced r o u n d w o o d , pulp mills lost a degree o f control over w o o d supplies. T h i s promoted pulp companies to become i n v o l v e d i n s a w m i l l i n g i n order to get an assured supply o f at least some o f the residual c h i p s . " (Interior P u l p Industry 1975)  28  T h e c h i p d i r e c t i o n p o l i c y was most often expressed as a c o n d i t i o n o f the cutting license, and was not f o r m a l l y incorporated i n any o f the P H A s .  2 7  It was also i n 1970 that  Weyerhaeuser introduced fibre supply contracts t y i n g residual c h i p prices to kraft p u l p prices. P r e v i o u s l y , prices h a d been f i x e d for a n extended p e r i o d o f t i m e (Weyerhaeuser, 1975). B y 1972, P r i n c e G e o r g e P u l p & Paper had also m o v e d to a p r i c i n g system relating the p r i c e o f chips to the m i l l net price o f p u l p .  2 8  T h i s practice  offormula pricing, where  the  price p a i d for w o o d chips is based o n a specified percentage o f the p u l p p r i c e , was widespread throughout the Interior p u l p and paper industry b y the early 1980s ( H a y - R o e 1983).  The Introduction  of Minimum  Chip  Pricing  and Export  Restrictions  T h e plentiful s u p p l y o f residual chips helped fuel a n e x p a n s i o n o f the Interior p u l p industry. T h e first signs o f trouble came w h e n prices i n N o r t h A m e r i c a n l u m b e r markets dropped i n the early 1970s, shortly after c h i p d i r e c t i o n had been introduced. A s s a w m i l l s shut d o w n , p u l p m i l l s , e n j o y i n g g o o d market c o n d i t i o n s , increased the prices they were w i l l i n g to pay for chips to keep the s a w m i l l s g o i n g . T h i s c o i n c i d e d w i t h the election o f the N D P government i n 1972. O n e o f the first issues the government started to e x a m i n e was the issue o f c h i p prices. A c c o r d i n g to the M i n i s t e r o f Forests, B o b W i l l i a m s , the p r o v i n c e had:  2 7  A n example of chip direction is contained i n a letter dated M a r c h 4, 1970 signed b y R a y W i l l i s t o n submitted by Inland T i m b e r Management to the Pearse C o m m i s s i o n .  "Established licensees within the above noted P u b l i c Sustained Y i e l d Units w i l l become eligible for additional cutting rights from 'third band' w o o d to be distributed on the basis o f detailed m i l l studies being carried out by the Forest Service ... A s a condition o f qualifying for such additional cutting rights, it Will be a requirement that existing timber sale licenses be converted to a timber sale harvesting license and that acceptable chip, sawdust, and hog fuel contracts have been executed w i t h the holder o f P u l p w o o d Harvesting A r e a N o . 2 [Kamloops P u l p & P a p e r ] . . . A n y established licensee not prepared to abide by such conditions w i l l not be able to participate i n any additional cutting right by reason o f the distribution o f 'third band' w o o d . Such licensees, however, w o u l d be required to operate to close utilization standards ... It is recognized that a fair price must be offered by the holder o f P u l p w o o d Harvesting A r e a N o . 2 for such w o o d chips, sawdust and h o g fuel, and I am confident that this w i l l be accomplished b y i n d i v i d u a l negotiation." ( L J . M i l n e r 1975)  B r i e f submitted b y Prince George P u l p to the R o y a l C o m m i s s i o n o n Forest Resources, dated A u g u s t 8, 1975, p. 17.  29  ". . . a p u l p market that is extremely buoyant, very profitable and a s a w m i l l industry that is pushed against the w a l l . . . the prices s a w m i l l s are r e c e i v i n g for their chips are b y and large generally b e l o w what they s h o u l d be... M i l l s i n the U n i t e d States ... are getting four, f i v e and s i x times w h a t producers i n B C are getting." ( M a r t i n 1974).  A t the same t i m e , the B C government had c o m m i s s i o n e d a report to investigate what C o a s t a l and Interior companies c o u l d afford to pay f o r w o o d chips as i t contemplated c h a n g i n g the stumpage system to incorporate the v a l u e o f w o o d chips. T h e first report were c o m p l e t e d i n late 1973, and suggested that p u l p m i l l s both o n the C o a s t and i n the Interior c o u l d pay m o r e for their chips than they were currently p a y i n g .  2 9  T h i s l e d to the N D P government to introduce B i l l 171 to establish m i n i m u m prices for residual chips a l o n g w i t h i n c o r p o r a t i n g the p r i c e o f w o o d c h i p s into the stumpage system. T h i s m o v e was v i e w e d w i t h s k e p t i c i s m b y the industry w h i c h , although c o m p a n y leaders had acknowledged.the p r o b l e m o f c h i p prices, were not sure that government controls o n c h i p p r i c i n g were necessary. Ian M a h o o d , then President o f the T r u c k L o g g e r s A s s o c i a t i o n , said: " . . . [w]e ...deplore the fact that i n the c h i p area it is apparent that transfer p r i c i n g i s b e i n g advocated—taking some o f the profit f r o m the p u l p m i l l s and transferring i t to the s a w m i l l s ... It i s far better to have prices related to the costs o f p r o d u c t i o n rather than have artificial p r i c i n g " ( M a r t i n 1975).  M a h o o d argued that the o n l y reason the government m a y have h a d to get i n v o l v e d was due to its stumpage p o l i c i e s i n the Interior, and that w h e n stumpage costs w e n t u p o n the C o a s t the p u l p companies v o l u n t a r i l y opened u p their contracts w i t h their c h i p suppliers and made adjustments.  30  T h i s d i d not happen i n the Interior as prices there were tied to escalation  G i v e n then current prices o f $210 per A D T for pulp, companies on the B C Coast were paying $26 to $32 per B D U delivered and could afford $32.75 to $41.75, while companies i n the Interior were p a y i n g $15 delivered i n the Interior ($20-$22 o n the N o r t h Coast) and c o u l d afford at least $ 2 5 per B D U (Roberts and Sawadsky 1973, A l e x a n d e r and Roberts 1973).  Stumpage rates i n the Interior were derived from lumber values at the time, while stumpage rates o n the Coast were determined by l o g values.  30  clauses relating to the price for p u l p , and the Interior p u l p m i l l s were w a i t i n g to see what the government was d o i n g regarding stumpage ( M a r t i n 1 9 7 5 ) .  31  Despite these concerns, the p r o v i n c i a l government proceeded w i t h B i l l 171 and the p o w e r to establish m i n i m u m c h i p prices was set through the T i m b e r Products S t a b i l i z a t i o n A c t i n the F a l l o f 1974 (this p r o v i s i o n still exists i n S e c t i o n 148 under the Forest A c t ) . T h e price o f residual chips was set i n i t i a l l y at $ 3 5 per B D U ( B r i t i s h C o l u m b i a 1 9 7 8 ) .  32  In addition,  the A c t was used to b r i n g residual chips under export controls for the first t i m e . T h e A c t also p r o v i d e d for the establishment o f a m a r k e t i n g board for w o o d c h i p s , although no such b o a r d was established at the time. F i n a l l y , the government simultaneously incorporated w o o d c h i p prices into the stumpage system for the Interior, u s i n g an a d m i n i s t r a t i v e l y determined price that was l o w e r than the m i n i m u m price set b y the p r o v i n c i a l government.  Initially the mandated c h i p price l e d to higher revenues for s a w m i l l s .  33  H o w e v e r , the first  signs o f a p r o b l e m s o o n s h o w e d up w h e n p u l p markets started to soften i n 1975, f o l l o w e d  3 1  T h e debate i n the legislature sheds some light o n the perceptions o f the market at this time. " G . G i b s o n ( L ) : ... 'even assuming chip prices are raised substantially, [it] is o n l y helpful to the independent operators so l o n g as the government forgoes its habitual taking o f something over 80 per cent of the increase i n prices ... W h a t is happening, really, is that is the government is finding another w a y to get revenue not out of the pulp m i l l s but out o f the p u l p mills and the independents ... the worst part about this section is that it permits the government to put the squeeze on any pulp m i l l or any independent operator i n this province ... I think most people o n the floor o f this House agree that a higher price should be paid for Interior chips. There's that m o n o p o l y buyer's market i n the Interior...There's just no question that it has to be fixed up. B u t to have it fixed up with total discretion on the part o f the Minister is wrong ... I suggest... that what is required is a formula ...that w i l l tie it to a free market.'"  G i b s o n goes o n to suggest using the coastal market after adjusting for transportation, and notes that the governments estimates o f chip prices coincide w i t h then current prices o n the Coast. ( B C L o g g i n g N e w s 1975: 22-23) 3 2  After pulp prices increased i n the first part o f 1974, the government c o m m i s s i o n e d another report o n chip pricing i n the F a l l o f 1974, w h i c h stated that w h i l e here were some o l d contracts i n force with prices o f $11-$12 B D U F O B the sawmill, newer contracts were being written at $20 per B D U , and there were reports o f special contracts to produce chips at $40 per B D U (Alexander and Roberts 1974). Coastal prices were $50 to $55 per B D U , and the report stated that i n the immediate short run Interior pulp m i l l s c o u l d afford to pay $60.  " . . . [ M ] a n y m i d d l e size operators found that their chip cheque was actually greater than their operating profit." ( B C L u m b e r m a n 1975)  31  b y a strike at the Interior p u l p m i l l s . W h e n the p u l p m i l l s reopened after the p r o v i n c i a l government legislated the strikers b a c k to w o r k i n O c t o b e r 1975, the p u l p m i l l s refused to take a l l the chips offered to t h e m ( B e r n s o h n 1981). T h e r e was n o requirement to purchase a l l the chips p r o d u c e d b y the s a w m i l l s , and chips started to p i l e up. S a w m i l l s noted that at $ 3 5 a unit, p u l p m i l l s were i n n o hurry to purchase w o o d c h i p s . In some cases, the g r o w i n g c h i p p i l e s meant that a s a w m i l l h a d to shut d o w n as it r a n out o f storage r o o m . O n e independent operator, A l T h o r l a k s o n , said "these c h i p p i l e s are a m o n u m e n t to bureaucracy...the S t a b i l i z a t i o n A c t s h o u l d be w i t h d r a w n and a m o r e rational price f o r chips s h o u l d be a l l o w e d to d e v e l o p . "  The Royal  Commission  34  on Forest  Resources  It was against this b a c k d r o p that a R o y a l C o m m i s s i o n , headed b y Peter Pearse, w a s struck b y the P r o v i n c e to investigate issues o f g r o w i n g concentration i n the forest industry a n d the role o f e c o n o m i c incentives i n forest management. A s part o f its w o r k , the C o m m i s s i o n also e x a m i n e d the issues o f m i n i m u m c h i p p r i c i n g , c h i p d i r e c t i o n p o l i c y , and c h i p export permits. H e a r i n g s were h e l d throughout the P r o v i n c e . N e a r l y every major c o m p a n y w i t h i n the P r o v i n c e made a s u b m i s s i o n to the hearing and it i s clear f r o m m a n y o f the submissions, f r o m both p u l p c o m p a n i e s and s a w m i l l s , that the s u p p l y a n d p r i c i n g o f p u l p fibre i n the Interior had b e c o m e a major issue w i t h i n the industry. F r o m the independent s a w m i l l ' s perspective, c h i p p r i c i n g w a s the major issue, a n d there was a consensus that c h i p d i r e c t i o n h a d l e d to l o w e r prices through r e d u c e d c o m p e t i t i v e pressures. C o n s i d e r these passages f r o m three entities that testified before the C o m m i s s i o n : " T h e f o l l o w i n g conditions affect c h i p market o p p o r t u n i t y : (a) C h i p d i r e c t i o n as a c o n d i t i o n o f most tenures. (b) F r e i g h t rates and car supply a v a i l a b i l i t y o n the B r i t i s h C o l u m b i a R a i l w a y seriously l i m i t additional d e l i v e r y points. (c) E x p o r t regulations effectively prohibit l o n g t e r m export. A producer o f chips connot [sic] contract to sell i n the export market f o r m o r e than a few months, whereas d o m e s t i c contracts c o v e r periods o f up to ten years. T h e market opportunity o n the basis o f a "spot" type export contract is o b v i o u s l y m u c h less favorable than o n a l o n g term contract.  3 4  See Chapter 23 i n Bernsohn (1981) for a good description o f these events.  32  In a d d i t i o n , " p u l p l o g " harvesting, close u t i l i z a t i o n a n d c h i p p i n g o f residuals i s effectively mandatory f o r the s a w m i l l industry. U n d e r the above circumstances, the C L M A reluctantly concludes that c h i p p r i c e regulation, although abhorrent i n p r i n c i p l e , i s inescapable i n practice." ( C a r i b o o L u m b e r M a n u f a c t u r e r s ' A s s o c i a t i o n 1975) " D i r e c t i o n o f chips, restrictions o n l o n g e r term exports and l a c k o f boxcars have severely aggravated an intolerable situation o f p u l p c h i p o v e r - s u p p l y i n the B C interior and p o o r e c o n o m i c s i n s a w m i l l s . T h e r i g i d nature o f the system o f d i r e c t i o n has f o r c e d the setting o f m i n i m u m p u l p c h i p prices, as natural market forces were not a l l o w e d to w o r k . W e expect that had these constraints not been o n the system that c h i p prices w o u l d have f o l l o w e d the rise i n p u l p prices m u c h m o r e c l o s e l y , and w h i l e prices i n some areas m a y not have reached $ 3 5 / B D U , c h i p producers w o u l d have been...generally better off." ( W h o n n o c k 1975) "It is readily apparent that i n the Southern Interior there i s a considerable v o l u m e o f tree material w h i c h is b e i n g burned at m i l l s or o n l o g g e d sites o r left to rot e v e n w h e n p u l p m i l l s are operating. It is also apparent that some o f the material licensees are required to r e m o v e costs m o r e to d e l i v e r and process through s a w m i l l s than it returns." ( R i v e r s i d e F o r e s t P r o d u c t s 1975)  T h e Interior p u l p c o m p a n i e s were concerned about what they felt had been the erosion i n their harvesting rights, and e s p e c i a l l y any further w e a k e n i n g o f the P H A s . "It is evident f r o m the foregoing that private contracts for the supply o f s a w m i l l residual chips are a n important part o f this f i r m ' s raw material security. F r a n k l y , the c o m p a n y w o u l d not have c o m m i t t e d capital to the K a m l o o p s p u l p m i l l w i t h o u t these contracts. T h e extent to w h i c h they rested i n c h i p d i r e c t i o n b y the C r o w n was h e l d to be a necessary part o f the arrangement." (Weyerhaeuser 1975) "It i s a l l v e r y w e l l to imply...that the a v a i l a b i l i t y o f residual chips reinforced b y the recently introduced " c h i p d i r e c t i o n " p o l i c y assures the p u l p m i l l s o f a supply o f r a w material, but this is not i n fact the case. T h e s a w m i l l s are not obligated to produce sufficient chips, and e v e n i f they do, transportation or other difficulties m a y prevent delivery o f the chips to the p u l p m i l l s . W e feel strongly that w e must continue to have protection against the p o s s i b i l i t y o f f i n d i n g ourselves dependent o n the vagaries o f the market f o r l u m b e r products. T h i s is w h y w e c o n s i d e r the guarantees o f a n independent s u p p l y o f w o o d contained i n our P H A A g r e e m e n t s to be the cornerstone o f our operations... A s a result o f the ' t h i r d b a n d ' p o l i c y , w h i c h made a v a i l a b l e to the s a w m i l l industry the remaining annual a l l o w a b l e cut resulting f r o m the change f r o m 'intermediate u t i l i z a t i o n ' to ' c l o s e u t i l i z a t i o n ' , a potential conflict arose between the o p t i o n granted to the p u l p m i l l companies under their P H A agreements to harvest or to acquire up to a certain v o l u m e o f r o u n d w o o d i f required and the cutting rights o v e r the same w o o d granted to the s a w m i l l s . " ( P r i n c e G e o r g e P u l p and Paper and Intercontinental P u l p 1975) " S o o n after the first P H A agreement was signed, the government, apparently r e s p o n d i n g to pressure f r o m s a w m i l l i n g interests and to the realization that some P H A s contained unallocated w o o d w h i c h , i f processed, c o u l d add to P r o v i n c i a l revenues one w a y or another, began p r o m o t i n g the use o f this w o o d i n s a w m i l l s . It appeared to reason that, i f enough s a w m i l l s c o u l d be enticed into u s i n g the additional w o o d , there w o u l d be an a m p l e  33  supply o f p u l p chips a v a i l a b l e without resorting to c h i p p i n g p u l p w o o d d i r e c t l y . T h e fallacy o f this assumption is readily evident u p o n r e a l i z i n g that: a) although some w o o d i s sound, it i s either too s m a l l to y i e l d marketable l u m b e r or, i f sawn, it produces a preponderance o f single d i m e n s i o n material s u c h as 2 " x 4 " ' s w h i c h , w h e n marketed i n large quantities, often suffers a f a l l i n market v a l u e to a price b e l o w the cost o f manufacturing. b) some w o o d does not produce marketable l u m b e r o f any grade and should not be processed i n s a w m i l l s . N o r t h w o o d agrees it was reasonable to a l l o w the e x i s t i n g s a w m i l l i n g industry or any n e w s a w m i l l s the rights to acquire unallocated w o o d , p r o v i d e d i t was generally w i t h i n the standards o f u t i l i z a t i o n i n force or d e v e l o p i n g at the t i m e . H o w e v e r , the government not o n l y allocated a l l the regular sized w o o d , but also the s m a l l and unmerchantable w o o d (for s a w m i l l i n g ) w h i c h i n most cases f o r m e d the basis for part o f the v o l u m e guarantees under the P H A agreement. A s matters stand today, s a w m i l l s c o m p l a i n , w i t h considerable v a l i d i t y , that m u c h o f the w o o d b e i n g forced o n t h e m by the close u t i l i z a t i o n p o l i c y is creating f i n a n c i a l hardships. T h e government has m o v e d to establish a base price for chips, w h i c h action helps to compensate for the shortcomings o f the close u t i l i z a t i o n p o l i c y but adds to the burden o f the pulp mills..." ( N o r t h w o o d P u l p and T i m b e r L i m i t e d 1975) A d a m Z i m m e r m a n , then President o f N o r t h w o o d P u l p and T i m b e r , also pointed out that the introduction o f the c h i p direction p o l i c y using P H A s had disproportionate effects: " W h a t was r e a l l y the p r o b l e m there was our o x was b e i n g gored [referring to c h i p d i r e c t i o n ] , i t was n i c e for some people but i t w a s n ' t g o o d f o r us, because w e had a f u l l y c o m m i t t e d P H A and w e bought c h i p s f r o m outside our o w n P H A ...but then this t h i n g [chip d i r e c t i o n ] . . .eliminated our opportunity to acquire those chips, and I t h i n k to go b a c k to y o u r earlier point, probably i m p a i r e d the market that existed, because there was n o market.. . . i f w e had been b u y i n g c h i p s f r o m someone i n P H A n u m b e r one, those w o u l d , i n effect, be p r e - e m p t e d b y this p r o v i s i o n , and the chips w o u l d l o g i c a l l y then f l o w to P r i n c e G e o r g e P u l p . S o it w a s n i c e for t h e m and nasty for us. (Pearse 1976a: 973-4) D a v i d S c h i n e , president o f C a n y o n C r e e k Forest Products, a s m a l l s a w m i l l i n V a l e m o u n t near the B C - A l b e r t a border, talked about the effect changes i n export p o l i c y h a d o n their exports to a p u l p mill i n Alberta. "..over the years, our export permits were getting lesser t i m e and I t h i n k they were d o w n to six months. A n d then f i n a l l y i n 1973 i t w a s not r e n e w e d . A n d it was suggested v e r y strongly that w e ship our c h i p s to someone i n P r i n c e G e o r g e , w h i c h w e d i d . " (quoted i n Pearse 1976a: 657-8) T r e v o r Jeanes, a registered forester w i t h B a l c o Industries (a f i r m w i t h s a w m i l l s i n the southern Interior), responded to a question f r o m D r . Pearse as to whether c h i p markets without regulatory constraints c o u l d be competitive. H e said that:  34  " . . . t h e r e ' s been a s l u m p i n the p u l p market. There perhaps i s not a competitive situation e x i s t i n g . P r i o r to that, I b e l i e v e there w a s . . . P r i o r to d i r e c t i o n o f c h i p s , w e s o l d chips to the coast, to other p u l p m i l l s that w e r e n ' t able to be used, or weren't able to be taken f r o m our m i l l by the plant l o c a l l y . " (quoted i n Pearse 1976a: 2842) M a r v i n Persson, m a n a g e r for Federated C o - o p , a s a w m i l l i n the S o u t h e r n Interior, described h o w the c h i p direction p o l i c y meant a l l their chips went to the p u l p m i l l i n K a m l o o p s . "..the d i r e c t i o n is not there for the berth c h i p s or f o r the T . F . L . c h i p s [two area based forms o f tenure different f r o m the P S Y U or v o l u m e based tenures through w h i c h the a d d i t i o n a l ' t h i r d b a n d ' w o o d h a d been issued]...the terms o f our contract says that w e w i l l sell a l l chips manufactured i n our operations, to the Weyerhaeuser C a n a d a c o m p a n y . " (quoted i n Pearse 1976a: 3 1 4 0 ) Pearse went o n to c o n f i r m that it was the contract, not the tenure, that required them to offer a l l o f their chips to the p u l p m i l l i n K a m l o o p s (Pearse 1976a: 3 1 4 1 ) . F i n a l l y , B u d N e l s o n , forester f o r G a l l o w a y L u m b e r , a s m a l l s a w m i l l i n the southeastern corner o f the P r o v i n c e , answered a question f r o m C o m m i s s i o n e r Pearse regarding whether his chips were directed to Crestbrook, the nearby p u l p m i l l . C o m m i s s i o n e r : A r e y o u free to sell t h e m somewhere else? N e l s o n : N o , not really. A t certain times n o w y o u c a n sell chips i f y o u get the refusal o f the p u l p m i l l , but generally, w h e n they refuse so does e v e r y b o d y else.Paughter] (quoted i n Pearse 1976a: 3 4 1 7 ) C r o w n Z e l l e r b a c h (now Fletcher C h a l l e n g e ) , w i t h s a w m i l l s i n the Interior and o n the Coast, and p u l p m i l l s o n the Coast, p r o v i d e d a different perspective. T h e c o m p a n y noted that c o m p e t i t i o n for supply contracts y i e l d e d the f u l l c o m p e t i t i v e p r i c e , as was the case o n the Coast, and that "as i n any l a n d l o c k e d r e g i o n , there is a n unavoidable degree o f regional imperfection i n the c h i p market. T h e r e i s n o w o n l y one buyer at K a m l o o p s . "  3 5  T h e c o m p a n y felt that government intervention was  unnecessary because the C o a s t offered a v i a b l e outlet for chips i n the K a m l o o p s area, d e p e n d i n g on export p o l i c y , transportation costs, and C o a s t a l p r i c e l e v e l s . T h e c o m p a n y also stated that i f  C r o w n Zellerbach 1976  35  there was to be any c h i p direction that it s h o u l d be matched b y a requirement to purchase directed v o l u m e .  In his f i n a l report, Pearse (1976b: 3 0 1 ) p r o v i d e d a detailed description o f h o w the c h i p export system w o r k e d at that time. T o receive approval for a c h i p export permit, a cornmittee made up o f C o a s t a l buyers and producers determined whether the chips i n question were surplus to the needs o f C o a s t a l p u l p and paper m i l l s . A l s o attending w a s a representative o f the Interior buyers, w h o p r o v i d e d their o p i n i o n o n whether the applicant's chips were surplus to Interior requirements. I f the applicant r e c e i v e d p e r m i s s i o n , the c h i p export permit w a s usually f o r a l i m i t e d t w o year p e r i o d , and contained a notice o f need p r o v i s i o n , w h i c h meant that either Interior or C o a s t a l consumers c o u l d i n v o k e the right to halt the export o f those chips and have t h e m redirected to their m i l l . D r . Pearse felt that the difficulties i n obtaining permits and their short duration also l i m i t e d export opportunities a n d i n turn the producers' ability to receive better prices and argued that the effect o f a l l these practices was to l i m i t market opportunities for w o o d c h i p producers.  Pearse (1976b: 302) r e c o m m e n d e d that the c h i p d i r e c t i o n p o l i c y s h o u l d be dropped (although the p u l p m i l l to w h i c h the chips were currently directed s h o u l d have a right o f first refusal) and that m i n i m u m c h i p p r i c i n g s h o u l d be exercised m o r e selectively. Pearse suggested that a forest products board s h o u l d be established to m o n i t o r c h i p prices and evaluate any structural impediments, such as inadequate transportation, that hampered the m a r k e t i n g o f c h i p s . Pearse (1976b: 3 0 2 ) also r e c o m m e n d e d that the government drop the export tax o n w o o d chips as w e l l as f a c i l i t a t i n g the export o f w o o d chips.  T h e N D P government c a l l e d an election i n the winter o f 1975 and lost to the S o c i a l C r e d i t Party w h i c h obtained a majority. In response to the c h i p surplus, the n e w l y appointed M i n i s t e r o f Forests, T o m W a t e r l a n d , announced i n M a r c h o f 1976 that the m i n i m u m price w o u l d drop to $ 3 0 per B D U . H e also announced that the government w o u l d p r o c e e d to  use a f o r m u l a where the p r i c e was based o n nine per cent o f the average s e l l i n g price per short ton o f bleached K r a f t p u l p for the p r e c e d i n g s i x m o n t h p e r i o d . T h e p r i c e w o u l d be adjusted every s i x months and the c e i l i n g o n freight costs borne b y the p u l p m i l l s w o u l d be raised to $ 1 4 per B D U (any transportation costs i n excess o f that w o u l d reduce the m i n i m u m p r i c e ) ( B C L o g g i n g N e w s 1976b).  T h e c h i p surplus continued to g r o w i n the Interior, and the government pressed the industry to c o m e up w i t h a solution to the p r o b l e m . Industry efforts to allocate the chips themselves had failed and the government threatened to establish a forest products m a r k e t i n g b o a r d i n order to resolve the p r o b l e m . I n response, the p u l p and paper companies announced that they w o u l d once again attempt to deal w i t h the c h i p s u r p l u s .  36  In the meantime, the government asked H u g h C o o p e r , a retired l a w y e r , to try and c o m e up w i t h a s o l u t i o n . C o o p e r ' s answer, after e v a l u a t i n g p o s s i b l e alternatives for w o o d c h i p s such as fuel or f o o d for l i v e s t o c k , l e d h i m to conclude that their highest value l a y i n m a k i n g p u l p . A tour o f E u r o p e and A s i a c o n v i n c e d h i m that sufficient d e m a n d existed overseas to warrant the d e v e l o p m e n t o f a n export outlet for Interior w o o d c h i p s ( B C L o g g i n g N e w s 1976c, C o o p e r pers. c o m m . 1995). B y the s u m m e r o f 1976 it had b e c o m e clear that the p r o b l e m c o u l d not be s o l v e d internally, and that exports offered the most p r o m i s e for h a n d l i n g excess c h i p s .  37  A l t h o u g h g l o b a l p u l p markets were poor, it was felt that exports at least meant that s a w m i l l s w o u l d n ' t have to burn their c h i p s . H o w e v e r , p u l p m i l l s argued that w h i l e they were not adverse to the export o f chips surplus to current needs, those chips m a y be required i n future years for additional planned domestic p u l p capacity. Estimates o f the surplus ranged f r o m 5 % to 2 0 % , and the D e p u t y C h i e f Forester said t r y i n g to get an exact  3 6  "Waterland said he had set no time table for the industry to reach a solution: ' T h e y (the p u l p producers) can see what the problems are and I k n o w they w i l l distribute the surpluses as evenly p o s s i b l e ' " . Vancouver Sun, Feb. 22, 1977.  3 7  "Forest M i n i s t e r T o m Waterland has had enough o f the bickering among the industry and has called a meeting for A u g u s t 10 where he w i l l read the riot act for what well c o u l d be the final t i m e . " Vancouver Sun, August 3, 1977.  figure w a s l i k e " t r y i n g to grab a handful o f j e l l y " ( B C L o g g i n g N e w s 1976c). R e s p o n d i n g to the p u l p a n d paper industry's concerns, the B C government stated that it d i d not want to discourage the establishment o f p u l p capacity i n the p r o v i n c e . Therefore, the permits w o u l d be f o r f i v e years a n d w o u l d be non-interruptible, w i t h p r o v i s i o n s f o r renewal i n the fourth year (although r e n e w a l w a s not automatic). It w a s felt that this w a s the t i m e p e r i o d necessary to satisfy buyers' requirements f o r fibre (although they preferred 10 year permits) as w e l l as the l e a d - i n time to b u i l d n e w p u l p capacity i n the p r o v i n c e ( B C L o g g i n g N e w s 1976c). I n a d d i t i o n , the l i m i t o n total exports w a s set at the l o w e r e n d o f estimates o f the surplus.  The  Formation  of Fibreco  Export  Inc.  T h e difficulty i n obtaining i n d i v i d u a l c h i p export permits l e d a group o f Interior s a w m i l l s i n 1977 to incorporate a c o m p a n y c a l l e d F i b r e c o E x p o r t , l e d b y C o o p e r . T h e p u l p m i l l s continued to m a i n t a i n their o p p o s i t i o n to the i d e a o f c h i p exports, a n d argued that e x p o r t i n g w o o d chips w a s i n effect e x p o r t i n g j o b s . C o o p e r accused the p u l p m i l l s o f deliberately rejecting the concept o f a n independent exporter because i t w o u l d usurp their control over , the m o v e m e n t o f c h i p s .  38  B y 1978, h o w e v e r , the p u l p a n d paper c o m p a n i e s ' o p p o s i t i o n h a d softened as it became clear that they c o u l d not consume a l l the chips b e i n g produced b y Interior s a w m i l l s .  3 9  In  the meantime, the government announced that due to poor p u l p market conditions it w a s l o w e r i n g the m i n i m u m p r i c e to $ 2 5 per B D U . P u l p prices then were h o v e r i n g around $ 3 0 0 per tonne (see F i g u r e 2) (Vancouver Sun, D e c e m b e r 2 4 , 1977). D i s c u s s i o n s n o w shifted  "[Hugh] C o o p e r [chairman o f Fibreco] accused the p u l p m i l l s o f deliberately rejecting the concept of Fibreco because it w o u l d usurp their control over the movement o f chips...Says Cooper bluntly: ' T h e y (pulp mills) feel i t ' s their G o d - g i v e n right to control the movement o f fibre i n the province. T h e y resent that there's an upstart organization that w i l l break that c o n t r o l . ' " Vancouver Sun, A u g u s t 3, 1977. ' " W e have never resisted a reasonable outflow o f chip (but) naturally any pulp company w o u l d get concerned i f there is a massive outflow,' says M a r k Gunther, President o f Prince George P u l p and Paper. ' A n d i f y o u take it to its ultimate c o n c l u s i o n y o u w i l l be exporting j o b s . ' " Vancouver Sun, August 3, 1977  38  to the length o f export contracts, w i t h independent s a w m i l l s p u s h i n g f o r 15 years, and the p u l p companies a r g u i n g f o r n o m o r e than f i v e years (Vancouver Sun, M a r c h 8, 1978). H o w e v e r , a c c o r d i n g to H u g h C o o p e r , b y n o w C h a i r m a n o f F i b r e c o E x p o r t , o p p o s i t i o n to exports h a d still not ceased, and F i b r e c o E x p o r t had to go outside the p r o v i n c e to f i n d the f i n a n c i n g f o r the export f a c i l i t y that had to be b u i l t i n V a n c o u v e r .  4 0  O r i g i n a l l y consisting o f thirty independent s a w m i l l c o m p a n i e s scattered across the Interior, F i b r e c o was based o n the concept o f a cooperative to use i n d i v i d u a l c h i p contracts to c o m e u p w i t h a p o o l o f chips f o r the Japanese market.  I n order to m a k e the c o n s o r t i u m v i a b l e ,  the members agreed to p o o l transportation costs so that each m e m b e r w o u l d receive a c o m m o n net price b y deducting the average transportation cost f r o m the export price. A s part o f this arrangement, because some o f the chips were c o m i n g f r o m great distances, C o o p e r arranged for some o f the Interior p u l p m i l l s to take their chips f r o m closer suppliers (i.e., c h i p swaps). F o r e x a m p l e , c h i p s f r o m F o r t N e l s o n went to M a c k e n z i e , o n l y a t h i r d as far as to the Coast. C o o p e r noted that it was not v e r y difficult to get the p u l p m i l l s to agree to this w h e n he c o u l d show t h e m the cost savings ( C o o p e r pers. c o m m . 1995).  F i b r e c o shipped its first l o a d o f chips September 2 9 , 1 9 7 9 . C o o p e r h a d been successful i n demonstrating that there was a substantial market for export chips w i t h the strongest d e m a n d c o m i n g f r o m the P a c i f i c R i m . H e signed a contract for 4 0 0 , 0 0 0 B D U s a n n u a l l y f o r ten years w i t h Japanese p u l p m i l l s . T h e export f a c i l i t y was designed to handle up to a m a x i m u m o f 7 5 0 , 0 0 0 B D U s annually. H e noted that export buyers wanted three assurances: first, that the B C government w o u l d not change its m i n d and that contracts w o u l d be l o n g term; second, that s u p p l y w o u l d be steady and not subject to interruptions; and third, that there be a g o o d tidewater h a n d l i n g f a c i l i t y . C o o p e r e m p h a s i z e d that the first c o n d i t i o n was extremely important. T h e r e was already a perception that B C was a n  C o o p e r attributed the p r o b l e m to the fact that every local bank had a p u l p and paper company officer sitting o n the board w h i c h had final approval o f a l l loans. (Cooper 1995)  unreliable source o f w o o d c h i p s i n the export market, based o n a series o f interruptions f r o m the C o a s t to the U S market i n Puget S o u n d i n the late 1960s.  41  C o o p e r pointed out that the Interior p u l p m i l l s were content to r e l y o n j u s t the residual chips that were a n inevitable byproduct o f l u m b e r production, and were f a i l i n g to utilize a l l o f the w o o d i n the forest ( H i b a l l e r , September 1979). C o o p e r also agreed that F i b r e c o ' s entry into the c h i p market c o u l d raise prices i n the Interior and stated that B C ' s Interior p u l p m i l l s had the l o w e s t fibre cost i n the w o r l d ( M a r t i n 1 9 7 9 ) .  4 2  T h e creation o f F i b r e c o E x p o r t appears to have c o i n c i d e d w i t h the development o f a quarterly report entitled the R e g i o n 1 A u d i t C o m m i t t e e Report, issued b y the C O F I C h i p T a s k F o r c e f o r m e d at the same time. T h e o r i g i n a l report appears to have been d r a w n up i n an attempt to quantify the c h i p surplus i n the Interior, and split the p r o v i n c e into three regions based o n c h i p p r o d u c t i o n and c o n s u m p t i o n : R e g i o n 1 c o v e r e d the N o r t h e r n Interior, i n c l u d i n g the N o r t h Coast; R e g i o n 2 c o v e r e d the Southern Interior; w h i l e R e g i o n 3 c o v e r e d the S o u t h C o a s t and V a n c o u v e r Island. T h e usefulness o f this report appears to have l e d to its c o n t i n u a t i o n o n a quarterly basis, funded by the industry, and it is currently circulated a m o n g p u l p m i l l s w i t h i n the r e g i o n . It appears that some C o a s t a l consumers also receive copies  4 3  T h e report purports to c o v e r a l l p r o d u c t i o n , c o n s u m p t i o n , a n d inventory  changes for a l l producers and consumers w i t h i n the r e g i o n , w i t h s o m e i n f o r m a t i o n about exports outside the r e g i o n (either to p u l p m i l l s outside the r e g i o n or to the export market).  4 1  C o o p e r (1981) stated that: "it was found i n the first foray into the international marketplace that it was l o n g recognized b y the international buyers o f w o o d chips that B r i t i s h C o l u m b i a was not the most reliable source o f supply for w o o d chips. O v e r the years there had been a vacillating p o l i c y on the export o f fibre from the province for various reasons: the vicissitudes o f political and economic factors o f changing governments and the l o b b y i n g pressures on governments by d i s s i m i l a r i l y [sic] interested groups."  4 2  E x p o r t prices were U S $ 91.25 per B D U i n the fall o f 1979 (Canadian P u l p and Paper Industry, November 1979), w h i l e Interior prices were $32 per B D U (the m i n i m u m price) ( B C L u m b e r m a n , September, 1979). Coastal prices ranged between $60-$64, and F i b r e c o had obtained contracts for $56 per B D U (Globe and Mail, December 13, 1979).  4 3  T h i s observation is speculative but is;based on conversations with industry participants.  40  The Forest  Act  of  1978  In 1978 the B C government introduced a n e w Forest A c t i n response to changes i n the forest industry and the r e c o g n i t i o n that t i m b e r quotas had become a de facto f o r m o f tenure ( B r i t i s h C o l u m b i a 1978). P S Y U s were replaced b y T i m b e r S u p p l y A r e a s , and licensees were a l l o w e d to convert their T S L s a n d T S H L s i n t o Forest L i c e n s e s ( F L s ) , v o l u m e based tenures w i t h fifteen year terms ( H a l e y 1995). I n terms o f the P H A s , the government had realized that s a w m i l l s had dramatically i m p r o v e d their ability to use s m a l l diameter w o o d , m a k i n g the d e f i n i t i o n o f p u l p w o o d e v e n m o r e a m b i g u o u s , and so had not issued any m o r e p u l p w o o d harvesting agreements after the i n i t i a l flurry i n the 1960's. T h e A c t changed P H A s to P u l p w o o d A g r e e m e n t s ( P A s ) replaceable every 10 years w i t h 2 5 year t e r m s .  44  P u l p w o o d A g r e e m e n t s that were subsequently granted also differed f r o m earlier P H A s b y clearly specifying the w o o d that w o u l d be available under the license w i t h the expectation that these licenses w o u l d be used for harvesting. T h i s was a substantial change f r o m the earlier agreements, w h i c h h a d o r i g i n a l l y been envisaged as p r o v i d i n g a b a c k u p source o f fibre (they h a d o n l y been used to a l l o w harvesting i n one instance).  Existing P H A s were  converted into P A ' s as their renewal terms c a m e up, although the terms o f the agreement remained unchanged until recently.  T h e f o l l o w i n g year (1979) saw a dramatic drop i n the l u m b e r market, w h i c h c o u p l e d w i t h higher stumpage rates, was p l a c i n g i n c r e a s i n g pressure o n s a w m i l l s yet p u l p prices were r i s i n g . H u g h C o o p e r predicted that s a w m i l l s w o u l d close g i v e n current l u m b e r and c h i p prices, w h i c h i n turn w o u l d d r i v e up c h i p prices as l o g g i n g was curtailed (the m i n i m u m p r i c e o f chips h a d n o w m o v e d up to $ 4 0 per B D U ) ( Vancouver Sun, D e c e m b e r 14, 1979).  Chip  Direction  Policy  Dropped  In 1980, the government issued a notice o f intent to a w a r d a new P A i n the W i l l i a m s L a k e area i n the C e n t r a l Interior o f the p r o v i n c e . T h i s w o u l d be the first such agreement  Section 1 7 A , Forest A c t o f 1978.  awarded under the n e w Forest A c t , and it attracted a great deal o f interest. T h r e e c o m p a n i e s , N o r t h w o o d , C a r i b o o , a n d Quesnel R i v e r P u l p , a p p l i e d for the w o o d , w h i l e several others m a d e general submissions u r g i n g the government to consider the i m p l i c a t i o n s o f a w a r d i n g a new P A . T h e hearings themselves c l e a r l y identified c h i p direction as the major issue i n the Interior p u l p fibre m a r k e t .  4 5  U l t i m a t e l y the M i n i s t e r o f Forests d e c i d e d not to a w a r d a p u l p w o o d a g r e e m e n t  46  The  minister, h o w e v e r , d i d drop m i n i m u m c h i p p r i c i n g , and replaced the c h i p d i r e c t i o n p o l i c y w i t h the right o f first refusal. T h i s right meant that the purchaser w h i c h h a d p r e v i o u s l y enjoyed the chips under c h i p d i r e c t i o n had the right to meet the best offer f r o m another purchaser before a s a w m i l l c o u l d sell to another p u l p m i l l (although e l i g i b l e buyers were restricted to other Interior p u l p m i l l s ) . T h e government also incorporated the f u l l v a l u e o f w o o d chips i n the stumpage system starting i n September, stating that the f u l l regional market price w o u l d be used (Province, M a r c h 9, 1980).  4 7  Independent s a w m i l l e r s w e l c o m e d the change, since they felt that r e m o v i n g these constraints w o u l d m e a n a market price m o r e reflective o f supply and d e m a n d conditions. S o m e , h o w e v e r , had some concerns about the change i n stumpage p o l i c y . S o m e industry  4 5  Quesnel R i v e r P u l p ( Q R P ) proposed to b u i l d a T M P m i l l i n Quesnel. West Fraser, w h i c h owned several sawmills i n the Northern Interior, had a fifty percent interest i n Q R P and was i n favor o f dropping chip direction as West Fraser's chips that c o u l d go to their proposed m i l l were being directed elsewhere. C a r i b o o was i n favor of continuing chip direction p o l i c y , since most o f the chips they received were directed. T h e i r chairman said "The whole basis o f the operation and the future revolves around that chip direction p o l i c y " . N o r t h w o o d stated that it was opposed to chip direction p o l i c y but couldn't risk seeing its supply o f chips jeopardized i f an applicant i n the area were able to get preferential treatment, as they anticipated acquiring additional fibre for a proposed expansion from the area advertised for the P . A . , w h i l e Canfor stated that they relied o n chip direction for their fibre needs. C r o w n Zellerbach urged the minister to reject all the applications and encourage an open market for chips (they required interior chips for an expansion o f their E l k Falls plant), while Canadian Cellulose (with the pulp m i l l at Prince Rupert) was worried about a d o m i n o effect from chips being redirected. (Province o f B r i t i s h C o l u m b i a 1981)  4 6  West Fraser, i n a joint venture with Daishowa, proceeded to build a thermo-mechanical ( T M P ) pulp m i l l i n Quesnel i n the early 1980's despite the fact that they d i d not receive a P A .  4 7  ' T h e stumpage system i n the Interior at the time was based o n the Rothery method. After computing the end product values that a l o g c o u l d y i e l d , costs and an allowance for profit and risk were deducted to arrive at the appraised stumpage price. C h i p s were not originally included as an end product until 1973 and then they were valued at $2 per B D U , c l i m b i n g to $10.50 b y the end o f 1980 (at w h i c h time the m i n i m u m price was $35.15 per B D U ) . " Province, M a r c h 9, 1980.  42  participants s a i d that s a w m i l l s w o u l d receive less under the n e w system than under the e x i s t i n g system (it was calculated that o f the $10 used i n the stumpage appraisal, the s a w m i l l kept $2), w h i l e others were c o n c e r n e d about what r e g i o n w o u l d be used to determine the price. S a i d one s a w m i l l e r : " N o w that w e have a n export market, we're m o r e o r less o n a n equal f o o t i n g w i t h the p u l p mills...they n o w have to c o m e up w i t h their p r i c e or w e export" (Vancouver Sun, M a r c h 8, 1980).  H u g h C o o p e r , then c h a i r m a n o f F i b r e c o , w a s a b i t m o r e s k e p t i c a l . W h e n a s k e d whether the higher export prices w o u l d squeeze the Interior consumers, he thought it u n l i k e l y as the Interior m i l l s , b e i n g the major consumers, w o u l d purposely h o l d their prices b e l o w what F i b r e c o was offering (Province, M a r c h 9 , 1 9 8 0 ) . T h i s v i e w p o i n t p r o v e d to be accurate: w h i l e export prices p a i d to F i b r e c o m e m b e r s increased to U S $ 9 9 per B D U for the next s i x months starting January 1 (Globe & Mail, F e b . 18, 1980), d o m e s t i c c h i p prices r e m a i n e d unchanged. C o o p e r attributed this to the fact that the most l i k e l y buyers f r o m outside the r e g i o n were not permitted to b i d f o r chips i n the r e g i o n , and that p u l p m i l l s i n the Interior saw n o need to raise p r i c e s .  48  C o o p e r t a l k e d about the p o s s i b i l i t y o f setting up c h i p p i n g stations i n P r i n c e G e o r g e , Q u e s n e l , a n d K a m l o o p s (Province, M a r c h 12, 1980) to meet the d e m a n d i n these other markets.  "Regulations dealing with w o o d chips i n the B C Interior took effect A p r i l 1 when Forests M i n i s t e r Thomas Waterland removed the floor price - w h i c h had been 9 per cent o f the selling price o f the pulp. H e also removed a requirement that sawmills i n certain areas had to sell their chips to designated pulp mills, holders o f p u l p w o o d harvesting area licenses. It was expected pulp mills needing chips w o u l d b i d , pushing up the price, but M r . C o o p e r said this has not happened for two reasons. P u l p mills were granted first refusal o f chips i n their harvesting area and option to buy at the price agreed i n the sale to 'others'. B u t the minister said o n l y other Interior pulp m i l l s c o u l d get i n v o l v e d i n this process, M r . C o o p e r said. T h i s excludes export buyers, w h o are paying about $100 a unit, and B C coastal pulp mills, w h i c h are paying $91 to $93 a unit. Interior pulp mills, w h i c h formerly kept their c h i p price at a m i n i m u m b y agreeing that nobody w o u l d pay more, are still d o i n g the same thing despite a change i n regulations, M r . C o o p e r said. C h i p prices are actually slightly l o w e r than before, he said. S u p p l y has been curtailed as sawmill operators attempt to w i t h h o l d their chips to get a higher price, but the boycott is not being completely maintained. T h e poor lumber market means ' e v e r y b o d y is scratching to pay his banker. T h e y need the cash f l o w ' . A s a result, Fibreco, w h i c h pays twice the pulp m i l l s ' price, 'is being deluged w i t h chips,' he said." Globe and Mail, A p r i l 9,  1980  43  T h e price o f l u m b e r continued to drop. A t this point, it was quite clear that w o o d chips and l u m b e r were co-products: at l o w enough l u m b e r prices, c h i p revenues determined whether a s a w m i l l stayed o p e n .  49  M a r k G u n t h e r , at P r i n c e G e o r g e P u l p and Paper, argued that  Interior p u l p m i l l s p r o v i d e d l o n g term markets for w o o d chips and c o u l d not be expected to pay the export price as it reflected spot p r i c e s .  50  G u n t h e r stated the answer was to tie c h i p  prices to the price o f p u l p ( m u c h as the m i n i m u m price had been determined), w h i l e H u g h C o o p e r responded b y n o t i n g that the p u l p industry w o r l d w i d e p a i d at least one-third o f the s e l l i n g price o f p u l p for their w o o d fibre. T h e Interior p u l p m i l l s responded to that argument b y saying that they faced higher transportation costs, w h i c h raised the cost o f fibre d e l i v e r e d to the m i l l s .  C o m p l a i n t s about c h i p p r i c i n g started to surface again o n the C o a s t i n 1987 as the p r i c e o f p u l p started to i n c r e a s e .  51  I n D e c e m b e r o f 1987, C a n f o r announced that they were  4 9  " F e w mills have closed so far, according to E . V . Scoffield, manager o f the Northern D i v i s i o n for C O F I . . . T h e main impact o f the ailing U S market is o n independent sawmillers, w h i c h unlike the larger, integrated companies, d o not have fat pulp and paper revenues to offset the lean times for lumber...Sales o f the byproduct chips can add $30 to $50 a thousand board feet to revenue, i f they are sold for export. Sales o f chips to Interior pulp mills w o u l d add o n l y $20 to $25, because they have been h o l d i n g the price d o w n , however, it is generally recognized that their price w i l l have to rise i f they are to get chips as lumber production is curtailed...Counting i n U S dollar exchange and chip sales, the total return to the miller from sawing a thousand board feet o f studs w o u l d be about $185 at export prices and about $165 at local pulp m i l l prices." (The article goes on to estimate average production costs at $160 per thousand board feet). Globe and Mail, A p r i l 26, 1980  5 0  ' T h e main fact probably is that there is still an oversupply o f chips i n the Interior... T h e Interior was set up by the government as a separate region for chips and it is a separate market," said G o r d o n T h o m s o n , vice-president, P u l p , for N o r t h w o o d P u l p and T i m b e r L t d . o f Prince George. 'It is pointless to c o m p l a i n that prices there are not as h i g h as elsewhere. W e ' r e going to pay what the market requires." M r . Gunther [of Prince George P u l p and Paper] said it is government p o l i c y that chips should not be transported out o f one region and that o n l y chips that are surplus to domestic requirements may be exported. In his v i e w , a surplus no longer exists. Globe and Mail, July 2 5 , 1980  51  " U n t i l recently, there was some negotiating i n v o l v e d i n setting chip prices and some variation i n the prices paid by the pulp producers. ' T h i s time, there were no negotiations,' said Joe Frumento, vice-president o f D o m a n . T h e majors said this is what we're paying and that's it'... A c c o r d i n g to M r . Frumento and other sawmill spokesmen, all o f the p u l p companies have offered the same prices, $70 a unit i n the case o f h e m l o c k . . . A s k e d w h y a l l the major companies are offering the same prices for w o o d chips, M r . Dent [general manager of raw material services for M a c m i l l a n Bloedel] said: ' C o m p a n i e s are not g o i n g to pay more than other companies are paying...we do not sit d o w n w i t h other major buyers and decide what the price is going to be for the next quarter.' A c c o r d i n g to M i k e T h o m p s o n , manager o f trading fibre supply for C r o w n Forest industries, prices as a percentage o f the p u l p price i n 1981 were higher because supplies were tighter and mills were whole l o g c h i p p i n g . H e said that there was currently a surplus o f chips on the Coast. T h e 44  undertaking a major expansion o f their m i l l i n H o w e S o u n d . Peter B e n t l e y , the c h a i r m a n , stated that the expansion was partly c o n d i t i o n a l o n chips currently b e i n g exported b e i n g re-directed to the p u l p m i l l .  5 2  Independent s a w m i l l e r s pointed out that  c u r t a i l i n g exports w o u l d reduce the pressure i n the market and l o w e r p r i c e s .  5 3  In 1987 the B C government adopted a n e w stumpage system i n response to a n A m e r i c a n trade action l a u n c h e d against C a n a d i a n softwood l u m b e r imports. T h e n e w system d e c o u p l e d c h i p revenues f r o m the stumpage system, u s i n g o n l y l u m b e r values to establish o v e r a l l stumpage l e v e l s , w h i l e c h i p prices were used to distribute the stumpage c h a r g e s .  54  T h i s system was k n o w n as the C o m p a r a t i v e V a l u e P r i c i n g system, or C V P . T h e new system also meant a significant increase i n stumpage prices i n the face o f p o o r l u m b e r prices, w h i l e p u l p prices had recovered f r o m their l o w s i n the first part o f the d e c a d e .  55  S a w m i l l s renewed their c o m p l a i n t s about the prices they were r e c e i v i n g for their w o o d c h i p s and the M i n i s t e r o f Forests, D a v e P a r k e r , t o o k t w o steps. T h e first was to l o o s e n export restrictions to m a k e it theoretically easier to grant permits, and the second was to ask  independents also said that i f they could sell them i n the U S they w o u l d get m u c h more for their chips; however, they can o n l y get two year permits, w h i c h is not l o n g enough to get a contract." Globe and Mail, A p r i l 2, 1987. 5 2  Bentley said he expects the expanded pulp m i l l w i l l need another 600,000 B D U s o f chips annually...Sawmillers interviewed...said the Interior industry is currently producing about 700,000 more B D U s than it can sell. Vancouver Sun, December 9, 1987.  5 3  "...Surinder G h o g o f A s p e n Planers...on the export restrictions being sought: 'These companies, Canfor included, the ones that operate the pulp m i l l s , use these means to regulate the price o f chips. Curtailing chip export permits is going to give them a more closed, in-house, situation, w h i c h is what they want, so there w i l l always be a surplus o f chips to keep chip prices as l o w as possible.'...Tony Jarrett [ o f Fibreco]: '...Restricting chip exports w o u l d ensure Canfor has the opportunity for a cheap c h i p s u p p l y . . . A n d what's bad about that is Canfor w o u l d be riding o n the backs o f the non-integrated s a w m i l l industry i n the Interior.'" Vancouver Sun, December 9, 1987  5 4  Under the C V P system put into place, lumber prices determined an overall target revenue rate. Differences i n end-product values (including type and species o f lumber as w e l l as chip prices) and operating costs were then used to distribute charges across firms cutting p u b l i c timber. Recent changes to the system lowered the level o f timber charges, and chip revenues are once again being used i n determining the overall target revenue rate.  5 5  " F o r many large, integrated forest product companies, the weak lumber market has been offset by rising prices for other commodities like newsprint and pulp that are used to make fine papers. B u t sawmillers are worried because their 'break-even range' is about $175 to $180 and their so-called 'shut-down range' is between $160 and $165, according to a recent R a n d o m Lengths survey o f B r i t i s h C o l u m b i a . That is a b i g change from the early 1980's, when U S sawmills were forced to close while their B C competitors, helped i n part b y l o w stumpage fees, kept producing even as the benchmark lumber price fell below $ 1 3 0 a thousand board feet." Financial Times, Sept. 26, 1988  45  the p u l p m i l l s i n the N o r t h e r n Interior to v o l u n t a r i l y raise their c h i p price. I n the S p r i n g o f 1988, C a r i b o o P u l p and Paper announced it was v o l u n t a r i l y raising its price $ 9 to $ 7 5 per B D U , w h i l e the p u l p m i l l s i n P r i n c e G e o r g e t o o k no action. A year later, concerned that s a w m i l l s m a y shut d o w n , P a r k e r again approached p u l p m i l l s i n the Interior, threatening to i n v o k e m i n i m u m c h i p p r i c i n g unless they raised their prices (Financial Post 1989).  A p p l e b y (1989) s h o w e d that although there was an o v e r a l l s m a l l surplus o f c h i p s that w e n t into the export market i n 1987, that surplus v a n i s h e d w i t h i n t w o years i f planned expansions i n p u l p capacity and reduction i n s a w m i l l i n g capacity were taken into account.  The  Granting  of 'New'  Pulpwood  Agreements  O n e o f the proposals the p r o v i n c i a l government d e c i d e d to investigate i n 1990 was the p o s s i b i l i t y o f a w a r d i n g p u l p w o o d i n the northwest area o f the Interior. A s had been the case i n 1980, nearly every c o m p a n y w i t h i n the r e g i o n either a p p l i e d for the p u l p w o o d license or intervened i n the hearings. S i x companies a p p l i e d for the fibre for a variety o f uses. T w o different p u l p and paper c o m p a n i e s i n the r e g i o n , C a n f o r a n d Q u e s n e l R i v e r P u l p , wanted the fibre as a b a c k - u p source, w h i l e a c o n s o r t i u m o f s a w m i l l s and A l c a n proposed to b u i l d a p u l p m i l l i n V a n d e r h o o f . O n e independent s a w m i l l e r wanted a p o r t i o n o f the proposed area that l a y near their e x i s t i n g cutting rights; and t w o other companies p r o p o s e d to use the deciduous species for s o l i d w o o d products. N o r t h w o o d a p p l i e d for intervenor status (along w i t h m a n y non-industry groups) to s u b m i t issues they felt that the m i n i s t e r s h o u l d address i n terms o f access to fibre ( P r o v i n c e o f B r i t i s h C o l u m b i a 1990). B y this time, the increase i n p u l p capacity had g r o w n to the point that g i v e n the anticipated increases announced and potential f a l l d o w n i n t i m b e r supply, a l l the p u l p a n d paper applicants were anticipating a shortfall i n the amount o f available chips relative to capacity.  T h e c h i p d i r e c t i o n p o l i c y c a m e up again i n the hearings, somewhat surprisingly since it had supposedly been dropped ten years p r e v i o u s l y . T h e government w a s pressed o n the i m p l i c a t i o n s for c h i p supply problems i f one applicant or another received the fibre, and once again the p r o v i n c i a l government decided not to a w a r d any o f the p u l p w o o d w i t h i n the area. O n e s t r i k i n g feature i n reading both p u l p w o o d hearings is to note h o w little appears to have changed i n the intervening ten-year period.  T h e p r o v i n c i a l government subsequently solicited proposals for additional u t i l i z a t i o n o f the forest resource for other areas i n the Interior. T h i s ranged f r o m proposals to use aspen i n the northeast corner o f the p r o v i n c e to produce p u l p and O S B and proposals to use stands o f s m a l l stagnated pine i n the central Interior. T h e p r o v i n c e had m a n y applicants, w i t h L o u i s i a n a P a c i f i c ( L P ) w i n n i n g the chance to set up first a C T M P m i l l i n C h e t w y n d , f o l l o w e d b y an O r i e n t e d Strand B o a r d ( O S B ) plant i n D a w s o n C r e e k (both r e l y i n g o n aspen). A i n s w o r t h L u m b e r was successful i n r e c e i v i n g the right to construct a  fibreboard  plant i n the central Interior u s i n g the s m a l l pine f o u n d i n the area. T h e government's m a i n c o n t r i b u t i o n was through the granting o f cutting rights i n the f o r m o f new P u l p w o o d A g r e e m e n t s that clearly specified the w o o d to be used for these facilities. I n addition, F i b r e c o had p r e v i o u s l y built a chemi-thermomechanical ( C T M P ) p u l p m i l l i n T a y l o r (this p u l p m i l l is n o w c o n t r o l l e d by S l o c a n ) , and later it r e c e i v e d a P A c o v e r i n g aspen i n the surrounding area.  'Chip  Shock  56  67  In 1990 s a w m i l l s i n the Interior approached then M i n i s t e r o f Forests, C l a u d e R i c h m o n d , to again ask for the government to put pressure o n the p u l p companies to raise their c h i p prices. T h e minister r e p l i e d that he w o u l d be unable to help and the N D P w o n the election  56  T h e o n l y additional facility using residual fibre since then has been a M D F plant i n Quesnel built by West Fraser i n 1997. T h e plant utilizes softwood chips, but West Fraser d i d not receive any additional cutting rights.  5 7  T h e phrase ' c h i p shock' was first used to describe Weyerhaeuser i n the U S suddenly d o u b l i n g the price for its exported chips to Japan i n 1980 (Marchak, 1995).  47  c a l l e d shortly thereafter ( E d g s o n 1995). L u m b e r prices l a n g u i s h e d u n t i l 1992, w h e n the l u m b e r market started to surge, f o l l o w e d b y the p u l p market i n 1994.  In F e b r u a r y 1994, S l o c a n (the largest independent s a w m i l l e r i n the Interior) announced that it was putting the entire c h i p supply f r o m its Q u e s n e l s a w m i l l up for b i d . T h i s had never happened before i n the Interior m a r k e t .  58  N e a r l y a l l o f the p u l p m i l l s i n the r e g i o n  responded, w i t h the w i n n i n g bidder, N o r t h w o o d , o u t b i d d i n g C a r i b o o P u l p , w h i c h h a d traditionally received a l l the chips f r o m that particular s a w m i l l . T h i s activity was watched w i t h a great deal o f interest b y other s a w m i l l s throughout the Interior, m a n y o f w h o m p r o m p t l y put their c h i p s up for b i d , and m a n y p u l p m i l l s f o u n d themselves s i g n i n g contracts at substantially higher prices w i t h n e w suppliers ( E d g s o n 1 9 9 5 ) ( B r a d f o r d 1 9 9 6 ) . P r i c e s o f c h i p s peaked i n 1995 at l e v e l s four times greater than they h a d been 59  o n l y 18 months e a r l i e r .  60  S e v e r a l p u l p and paper m i l l s f i l e d a "notice o f n e e d " i n 1994, a p r o v i s i o n under w h i c h they can request the government to halt the export o f chips and have t h e m re-directed to their m i l l . T h e government response i n 1995 was to not issue any new export permits and not renew to o l d ones as they e x p i r e d . I n addition, the p r o v i n c i a l government revised stumpage rates i n M a y , 1994, s u c h that at higher prices for l u m b e r the stumpage rate was significantly h i g h e r (the n e w stumpage rates became k n o w n as " S u p e r Stumpage").  I was unable to find any participant w h o had any recollection o f such an event or any record happening prior to this i n the Interior. O n e participant (from a mid-sized s a w m i l l ) recalled that when they had offered some chips previously to a p u l p m i l l w h i c h hadn't purchased chips from them the p u l p m i l l had indicated that they w o u l d be interested but first needed to "check" w i t h the pulp m i l l that was currently purchasing their chips. After checking, the potential purchaser indicated that they were no longer interested. T h i s can be seen i n the C h i p A u d i t Task Force report as w e l l . Somewhat ironically, several Interior sawmillers suggested i n trade discussions w i t h the U S forest industry that part of" the reason for the success o f the Interior forest industry lay i n the chip prices they were receiving, due to the competitive nature o f the market. T h e sawmillers suggested that pulp and paper m i l l s i n the U S South had depressed chip prices.  48  T o get more chips, several interior p u l p m i l l s also attempted to activate their cutting rights under their o l d P H A s that had been converted into P A s . T h i s has presented a c o n t i n u i n g p r o b l e m for the p r o v i n c i a l government due to the vague definitions o f "material suitable for p u l p i n g " i n the o r i g i n a l agreements. Furthermore, the government f o u n d itself w i t h the p r o b l e m that s o m e o f this w o o d was either already c o m m i t t e d , as part o f l o n g range harvest projections, o r f e l l under m o r e than one license as the o r i g i n a l P H A s h a d been e x p l i c i t i y o v e r l a i d o n top o f existing forest licenses w h e n they were o r i g i n a l l y established. T h e p r o b l e m was made m o r e c o m p l i c a t e d because m a n y s a w m i l l s had installed w h o l e l o g chippers, g i v i n g t h e m the c a p a b i l i t y to handle l o g s too s m a l l to saw.  T h r e e o f the o r i g i n a l P H A s that have been subsequently renewed i n the past several years have substantially changed t e r m s .  61  F o r e x a m p l e , the agreements are no l o n g e r renewable  and expire at the end o f their terms w h i c h u s u a l l y consist o f 2 0 years. F u r t h e r m o r e , p u l p w o o d is n o w defined as p u l p quality t i m b e r stands, and i s n o l o n g e r defined as b e i n g b e l o w s a w m i l l u t i l i z a t i o n standards; rather, they m a y f a l l b e l o w s a w m i l l u t i l i z a t i o n standards f r o m t i m e to t i m e .  F i n a l l y , the o r i g i n a l agreements stated that timber w o u l d o n l y be harvested i f the licensee was unable to obtain sufficient fibre b e l o w the cost o f harvesting and processing r o u n d w o o d itself. T w o o f the h i s t o r i c a l P A s (numbers 3 and 7) n o l o n g e r require this c o n d i t i o n to be met, rather, the c o m p a n y c a n i n v o k e the P A i f they feel the fibre available o n the market i s too expensive. T o date, the B C government still has not i n d i c a t e d h o w they w o u l d handle a request to use s u c h a n agreement.  T h e r e have also been other noticeable developments. I n 1995 C a n f o r , a n integrated c o m p a n y w i t h p u l p m i l l operations i n both P r i n c e G e o r g e and o n the Coast, attempted a hostile takeover o f S l o c a n . T h e purpose o f the takeover was to secure S l o c a n ' s s u p p l y o f  6 1  P A 1, held by Canfor and renewed N o v e m b e r 22, 1993; P A 5, held by C a r i b o o P u l p & Paper and renewed December 16, 1996; and P A 7, held by Canfor and renewed January 24, 1997.  49  w o o d c h i p s . I n 1996, O r e n d a Forest Products, w i t h cutting rights o n the N o r t h Coast, announced that an offer had been made to purchase the c o m p a n y subject to it r e c e i v i n g approval to transfer the t i m b e r cut to V a n c o u v e r Island. T h e p u l p m i l l i n P r i n c e R u p e r t that received part o f its p u l p fibre requirements f r o m O r e n d a opposed the deal and subsequently acquired O r e n d a f o r its cutting rights.  Canfor's attempted takeover o f S l o c a n raised a n issue that has been o f c o n c e r n i n B r i t i s h C o l u m b i a since the Pearse C o m m i s s i o n i n the m i d - 1 9 7 0 s . Press releases b y the M i n i s t r y o f Forest at the time o f the proposed takeover suggested that C a n f o r , i f successful, w o u l d control 5 0 % o f the l o c a l w o o d c h i p market. T h e takeover f a i l e d for at least t w o reasons: (1) the M i n i s t e r stated that he w o u l d v i e w the increased concentration w i t h c o n c e r n (and the B C government retains the right to refuse the transfer o f cutting rights); and (2), a share b u y - b a c k b y S l o c a n . I n order to finance the share b u y - b a c k , S l o c a n entered into a l o n g term arrangement w i t h Weyerhaeuser for 1 m i l l i o n B D U s over the next ten years; o n a n annual basis, this is about 1 6 % o f their 1993 p r o d u c t i o n .  62  A s part o f the b u y b a c k ,  h o w e v e r , S l o c a n agreed to Weyerhaeuser t a k i n g a 2 0 % interest i n S l o c a n i n the event o f a default. T h i s has raised concerns a m o n g other independent s a w m i l l i n g c o m p a n i e s , since S l o c a n is the largest seller o f w o o d chips i n the Interior. C a n f o r has subsequently purchased a m i n o r i t y interest i n three o f the largest r e m a i n i n g independent s a w m i l l s i n the P r i n c e G e o r g e area.  P o o r p u l p markets, c o u p l e d w i t h h i g h fibre inventories, f o l l o w i n g the spike i n prices i n 1995 l e d to c h i p prices t u m b l i n g b a c k to the l e v e l s o f the early 1990's. Subsequently, h o w e v e r , c h i p price l e v e l s have r e m a i n e d s l i g h t l y above those i n the past, w h i l e prices are m o r e w i d e l y dispersed than i n the past. O n c e again, the p o s s i b i l i t y o f s a w m i l l s shutting d o w n due to the state o f p u l p markets was b e i n g d i s c u s s e d .  63  Slocan A n n u a l Report 1996. See, for example, the various articles that have appeared i n the Vancouver Sun: B C Forestry i n perilous position, November 29, 1996; Stumpage Fees going up, industry warned, November 29,  50  O n e o f the major news stories o v e r the past year i n the forest industry has been the e c o n o m i c w o e s o f the p u l p m i l l i n P r i n c e R u p e r t o w n e d b y S k e e n a C e l l u l o s e . A f t e r m i s s i n g m u c h o f the h i g h p u l p prices i n 1995 due to a strike, the p u l p m i l l c a m e b a c k o n l i n e just as p u l p prices started to tumble. S h o r t l y thereafter A v e n o r undertook discussions w i t h the parent c o m p a n y , R e p a p , o v e r p u r c h a s i n g R e p a p ' s assets. D u e to R e p a p ' s h i g h debt l o a d , and the unattractive e c o n o m i c s o f R e p a p ' s B C p u l p m i l l , w h i c h relies o n p u l p l o g s as w e l l as w o o d c h i p s f r o m the Interior, R e p a p divested itself o f its w h o l l y - o w n e d B C subsidiary ( w h i c h also i n c l u d e d several s a w m i l l s i n the northwestern part o f the p r o v i n c e ) . T h i s threw the B C subsidiary into bankruptcy and into the arms o f the t w o banks, T o r o n t o D o m i n i o n and R o y a l B a n k , that h e l d the major p o r t i o n o f the debt.  T h e p r o v i n c i a l government made the p o l i c y d e c i s i o n that it c o u l d not let the p u l p m i l l close due to the negative e c o n o m i c i m p a c t it w o u l d have o n the surrounding r e g i o n .  64  I n i t i a l discussions l e d to  the p r o v i n c e a d v a n c i n g the c o m p a n y funds and then purchasing R o y a l B a n k ' s interest, a s s u m i n g a majority equity share i n the c o m p a n y . T h e government has also p r o v i d e d f i n a n c i n g assistance to defray l o g g i n g and forest m a n a g e m e n t expenses, as w e l l as deferring stumpage payments and r e l a x i n g u t i l i z a t i o n standards. T h e total cost to taxpayers is estimated to be over $ 3 0 0 m i l l i o n , m a k i n g it the most expensive a i d package i n the history o f the p r o v i n c e . H o w e v e r , the m i l l remains one o f the highest cost producers i n B C , due both to the nature o f its fibre supply and its l o w labour p r o d u c t i v i t y , and its prospects are somewhat uncertain i n the face o f current l o w p u l p prices. O n e p u l p l i n e continues to r e m a i n i d l e d as o f early 1999 as p u l p prices have f a i l e d to reach sufficient levels to warrant restarting the p r o d u c t i o n l i n e .  In s u m m a r y , the development o f the p u l p and paper industry i n the Interior has been intertwined w i t h that o f the s a w m i l l industry and government p o l i c y . T h e creation o f a market for w o o d ,  1996; Terrace sawmill to shut d o w n , l o g g i n g costs cited, November 28, 1996; Problems just tip of the iceberg i n B C , N o v e m b e r 2, 1996. 6 4  T h i s also happened after the government had introduced the much-touted Jobs and T i m b e r A c c o r d , w h i c h promised to provide substantial new numbers o f jobs i n the forest industry. M a n y observers felt that the government simply c o u l d not let such a visible portion of the forest industry close given the political rhetoric surrounding the A c c o r d .  51  p r e v i o u s l y wasted, simultaneously p r o v i d e d the basis for the p u l p industry i n the Interior i n the f o r m o f a n abundant and l o w - c o s t source o f fibre w h i l e b r i n g i n g stands that were p r e v i o u s l y considered unmerchantable w i t h i n the e c o n o m i c m a r g i n o f the Interior s a w m i l l i n g industry. B o t h sectors grew r a p i d l y as harvest l e v e l s , l u m b e r p r o d u c t i o n , and residual c h i p p r o d u c t i o n increased, c o m p l e m e n t i n g each other, as seen i n F i g u r e 1 and T a b l e s 2 a n d 3. C h a n g e s d u r i n g that p e r i o d i n both the allocation o f t i m b e r rights and charges for timber have reflected that interdependence: h i g h e r stumpage charges have l e d to increases i n c h i p prices, w h i l e issues o f c h i p and p u l p fibre s u p p l y has been b e h i n d m u c h o f the recent restructuring i n the B C forest i n d u s t r y .  65  In 1999, h o w e v e r , m a n y o f the issues f a c i n g the industry i n the Interior arise f r o m the i m p l i c a t i o n s o f decreasing fibre availability due to the reduction i n A A C . T h e development o f engineered w o o d products has increased the d e m a n d for residual w o o d c h i p s , w h i l e techniques s u c h as fingerj o i n t i n g w h i c h u t i l i z e w o o d residue that was f o r m e r l y c h i p p e d , have decreased the supply. O v e r s h a d o w i n g those trends have been reductions i n harvest levels and greater reliance o n poorer quality timber that are also changing the structure o f the Interior market w i t h i m p l i c a t i o n s for the cost o f p u l p fibre and the a l l o c a t i o n o f f i b r e .  T h e p r o v i n c i a l government finds itself f a c i n g i n c r e a s i n g l y difficult p o l i c y choices. I n the past, the traditional approach to e c o n o m i c development i n the forest industry has been to grant access o r tenure rights to process the fibre b y i n d u s t r i a l users. N o w , h o w e v e r , i t i s d i f f i c u l t for the government to f i n d any u n c o m m i t t e d fibre. Furthermore, the p r i c e c y c l e s are shorter and o f greater amplitude, and c h a n g i n g technology m a k e it difficult to establish what uses w i l l p r o v i d e the highest e c o n o m i c value i n the future. E x i s t i n g operators argue that any available fibre s h o u l d be used to sustain their operations and to m a i n t a i n current e m p l o y m e n t .  O n the B C Coast, M a c M i l l a n Bloedel spun off its pulp and paper d i v i s i o n i n two steps, forming two new companies, Harmac Pacific i n 1994 (subsequently acquired by Pope & Talbot) and Pacifica i n 1998. Timberwest divested itself o f its public cutting rights w h i c h were sold to D o m a n , w h i c h has two pulp mills on the B C Coast. 52  F i n a l l y , increased stumpage charges over the past several years have l e d to m u c h l o w e r e c o n o m i c m a r g i n s for the forest industry and losses f o r some, and the government n o w faces the additional issue o f ensuring that stumpage prices are appropriately set and accurately measure t i m b e r values. T h i s task also becomes m o r e difficult i n the face o f r a p i d l y c h a n g i n g product prices. A t this point, then, it is instructive to e x a m i n e the e c o n o m i c forces that determine prices for p u l p fibre and what impacts these changes have o n p u l p fibre prices.  53  2.  R E V I E W O F E C O N O M I C  T H E O R Y  "Theoretically, pulpwood markets can be characterized either as oligopsonistic or monopsonistic.the prevailing pattern of pulpwood procurement is that of buying from large numbers of small suppliers who sell to a single mill or to a few mills located in close proximity to one another. As a consequence of this type of market structure, price determination is dominated by the buyers... There is, of course, considerable incentive on the part of pulp and paper companies to keep the prices they pay for pulpwood as low as possible. And attempts to do so are facilitated by the fact that purchasers in an area are always few, and competing mills are well aware of the price their rivals are paying." , Guthrie 1950  Market  Power  and Price  Discrimination  Forestry e c o n o m i c s has l o n g r e c o g n i z e d the potential f o r imperfect markets i n forest inputs. T h e e c o n o m i c s o f processing r a w material usually makes i t i s less costly to process i t as close to the harvesting site as possible, g i v e n the h i g h transportation costs per unit o f r a w m a t e r i a l . S i n c e forests tend to be quite w i d e l y dispersed a n d distant f r o m e n d markets, i t i s quite c o m m o n then f o r there to be l i m i t e d numbers o f potential buyers i n standing t i m b e r markets ( G r e g o r y 1987). M e a d (1967) investigated the issue o f c o m p e t i t i o n i n his classic w o r k o n federal t i m b e r markets i n the U S P a c i f i c N o r t h w e s t a n d s h o w e d that as the n u m b e r o f buyers increased the w i n n i n g bids f o r p u b l i c timber were higher. M e a d also s h o w e d that larger f i r m s were able to successfully acquire federal timber at l o w e r cost than their smaller competitors.  T h e p r o b l e m o f market p o w e r becomes even m o r e acute i n the p u l p a n d paper industry, as the large economies o f scale prevalent i n the p u l p a n d paper industry increase the size o f harvesting areas, further r e d u c i n g the l i k e l i h o o d o f alternative buyers. T h e p r i c i n g o f p u l p w o o d a n d w o o d chips has not o n l y been a c o n c e r n i n B C ( N e l s o n et a l . 1994, G a s t o n et a l . 1995), but also i n t i m b e r markets i n C a n a d a a n d the rest o f the w o r l d : Q u e b e c ( O l s o n 1989); O n t a r i o ( N a u t i y a l 1995); N e w  54  B r u n s w i c k ( R u n y o n 1983); A l b e r t a (Geldhart and C a r r o l l 1980); A u s t r a l i a (Parker 1988); S w e d e n (Johansson a n d L o f g r e n 1983); and the U n i t e d States ( M u r r a y 1992).  M a r k e t p o w e r c a n be defined as the ability o f one o r more o f the participants i n a market to influence the p r i c e l e v e l o n a sustained basis through their actions. T h i s stands i n sharp contrast to perfectly c o m p e t i t i v e markets, where there are so m a n y buyers and sellers that no i n d i v i d u a l party has the ability to affect the market price l e v e l through their actions. I n essence, there is n o market power; a l l sellers are " p r i c e takers"; and f i r m s as buyers are price takers as w e l l .  6 6  T h e goal o f f i r m s w i t h market p o w e r i s to increase their profits, and the most c o m m o n firms use to pursue that goal is through u s i n g their ability to affect price l e v e l s ( P i n d y c k and R u b i n f e l d 1989). T h e standard m o d e l used to e x a m i n e market p o w e r o n the purchasing side is that o f a monopsony, w h e r e a s i n g l e f i r m i s the o n l y purchaser o f a g o o d or service. B e c a u s e the monopsonist recognizes that as it increases its purchases that it raises the price i n the market, it w i l l choose the price and quantity c o m b i n a t i o n that m a x i m i z e its profits. U n d e r such circumstances the monopsonist uses its m a r k e t p o w e r to pay a price l o w e r than w o u l d prevail i n m o r e c o m p e t i t i v e markets. F i g u r e 4 shows that i n a competitive market, the quantity O E w o u l d be purchased at a price o f O B where supply ( S ' ) i s equal to d e m a n d ( D ) . A p u l p m i l l w i t h market p o w e r w o u l d choose to purchase the quantity O C and pay O M , where the m a r g i n a l expenditure ( M E ) equals the m a r g i n a l revenue ( D ) . B y p a y i n g a l o w e r p r i c e , the p u l p m i l l i s able to extract producer surplus f r o m the suppliers equivalent to the rectangle B M G H , w h i l e society faces a deadweight loss equivalent to the triangle F H J .  The concept o f a f i r m ' s ability as a determinant o f market power lies behind the idea o f contestability used i n the analysis o f monopolies. E v e n though a m o n o p o l y may possess the power to change prices i n its market, it may be unable to raise prices above its costs due to the possibility of entry b y other firms. A l t h o u g h the f i r m can meet the demand i n the market, i f it attempts to raise prices another f i r m can enter the market at an infinitesimally l o w e r price and supply the entire market. A i r l i n e routes are the typical examples o f contestable markets.  Figure 4. Pricing Under Competitive Conditions and Under a Monopsony  , A firm w i t h market p o w e r w i l l find that it m a y be able to increase its profits i f it c a n p a y different prices to different sellers o f a n input. I n F i g u r e 4, the p u l p m i l l c o u l d increase its profits b y the triangles A M H and G H I i f it c o u l d pay just e n o u g h to each supplier to c o v e r the costs o f p r o d u c t i o n ( i n this case, the l i n e A I ) . I n this case, the p u l p m i l l is practicing price discrimination. P r i c e d i s c r i m i n a t i o n occurs w h e n e v e r a firm charges (or pays) different prices f o r the same g o o d (where a l l differences i n the product due to quality, date o f d e l i v e r y , quantity, or transportation costs have been accounted for) to different buyers (sellers).  A s a general rule, profits increase under price d i s c r i m i n a t i o n . I n the e x a m p l e above, the firm was p r a c t i c i n g perfect or first-degree price discrimination: each supplier r e c e i v e d just enough to i n d u c e them to offer their supply a n d the purchaser is able to c o m p l e t e l y capture a l l the producer surplus i n the case o f a seller p r a c t i c i n g perfect price d i s c r i m i n a t i o n , it captures a l l o f the c o n s u m e r surplus).  A m o r e c o m m o n practice is third-degree price discrimination w h e r e customers (suppliers) can be separated into different groups that have different d e m a n d (supply) curves. T h e  firm  can then establish different prices for each group based o n some characteristic that it c a n use to d i s t i n g u i s h between the different groups (and must be able to prevent arbitrage). I n order for this strategy to be successful, the purchaser has to be able to identify the source for a particular supply, as different prices m a y m a k e it profitable f o r a group that receives a l o w e r price to try a n d market its supply as c o m i n g f r o m the h i g h e r p r i c e d g r o u p .  67  Note  that even i f suppliers i n different locations receive the same net price, the purchaser i s p a y i n g different prices as the cost o f the g o o d i n c l u d e s transportation costs. A n y c o m p a r i s o n o f the prices p a i d for goods has to i n c l u d e a l l costs o f getting the g o o d to the m i l l , i n c l u d i n g any quality or transportation differences as w e l l as transaction costs.  67  One c o m m o n example o f such arrangements for firms selling goods are special prices for students and seniors. In terms o f such arrangements o n the purchasing side, B i n k l e y (1991)observes that p u l p w o o d buyers i n the A m e r i c a n Southeast may set up area or zone-specific prices.  57  W h e n there are f e w f i r m s purchasing a g o o d the market structure i s described as a n oligopsony. F i r s t o r third-degree price d i s c r i m i n a t i o n m a y be present under a n oligopsonistic market structure; however, the nature o f the market m a y be such that the purchasers are unable to exercise any market p o w e r whatsoever. O l i g o p s o n i s t s face the p r o b l e m that to the extent f i r m s are successful i n earning true or e c o n o m i c profits, a n incentive i s created f o r f i r m s to try to "cheat" ( p a y i n g slightly m o r e to receive more o f the good). I f a l l f i r m s engage i n such behavior, the prices w i l l revert to m o r e competitive price levels (one example o f this f o r a n o l i g o p o l y has been the i n a b i l i t y o f the O P E C cartel to sustain the h i g h o i l prices they agree to i n their annual meetings). T h e i n a b i l i t y o f firms to fully coordinate their behaviour i n a n o l i g o p o l y o r o l i g o p s o n y adds a n additional layer o f c o m p l e x i t y i n t r y i n g to understand the exercise o f market power.  Models  of Pulpwood  Markets  Because p u l p w o o d markets c o m m o n l y e x h i b i t the characteristics that are assumed to be associated w i t h market power, such as l i m i t e d numbers o f purchasers relative to suppliers, several m o d e l s have been developed to e x a m i n e imperfect c o m p e t i t i o n i n p u l p w o o d markets.  L o w r y and Winfrey  (1974) pointed out that i n the U S Southeast that p u l p a n d paper companies w i l l source m o r e expensive p u l p w o o d f r o m their o w n forestland at a cost that i s higher than purchased p u l p w o o d . T h e y argue that the purchaser believes that the p u l p w o o d supply curve i s very inelastic; any increase i n d e m a n d i s l i k e l y to b r i n g about r a p i d increases i n p r i c e without increasing s u p p l y substantially.  L o w r y a n d W i n f r e y also note that this practice w i l l tend to depress the price o f  forestland, w h i c h aids i n the acquisition o f additional timberland. B j u g g r e n (1992) uses the same argument to e x p l a i n w h y S w e d i s h p u l p m i l l s w i l l i m p o r t far m o r e expensive r o u n d w o o d , rather than attempting to purchase m o r e domestic r o u n d w o o d w h e n they require additional f i b r e , a n argument also used b y Johansson a n d L o f g r e n (19S3) to e x p l a i n apparent excess d e m a n d i n the S w e d i s h r o u n d w o o d market. I n these cases, f i r m s e x p l o i t pre-existing m a r k e t segments to take advantage o f differing supply elasticities.  6 8  T h e y also argue that the price is sticky; once the price has increased, it is u n l i k e l y to fall as  58  G a s t o n , N e l s o n , a n d Stanbury (1995) use such a m o d e l to e x p l a i n price d i s c r i m i n a t i o n i n the B C C o a s t a l p u l p fibre market, where the relatively inelastic p r o d u c t i o n o f w o o d chips, c o m p a r e d to the m o r e elastic supply o f p u l p l o g s , permits purchasers to p a y m a r k e d l y less for residual chips than for r o u n d w o o d c h i p s .  6 9  7 0  A n o t h e r approach has been to incorporate the interaction between market p o w e r and l o c a t i o n where firms act as spatial monopsonists and practice price d i s c r i m i n a t i o n . B i n k l e y (1991) e x a m i n e d p r i c i n g systems for p u l p w o o d i n the U S S o u t h and s h o w e d the advantages o f zone p r i c i n g , where purchasers establish prices for a particular supply area to take advantage o f differing supply elasticities.  71  L o f g r e n (1985), using a spatial m o n o p s o n y m o d e l , shows that the o p t i m a l p r i c i n g  system depends o n the elasticity o f the supply curve, and argues that the resulting price system i n S c a n d i n a v i a therefore reflects a c o n c a v e supply curve. G e l d h a r t and C a r r o l l (1980) propose a m o d e l o f first-degree price d i s c r i m i n a t i o n where the delivered cost to the p u l p m i l l varies directly w i t h the transportation cost t a n d the suppliers, or s a w m i l l s , are ordered b y distance. I n the m o d e l , a l l s a w m i l l s have the same cost o f c h i p p i n g and can produce equal amounts o f chips i f their supply price i s met (the supply i s f i x e d for each i n d i v i d u a l s a w m i l l and o v e r a l l supply i s increased b y purchasing f r o m additional s a w m i l l s ) . I f the p u l p m i l l c a n pay supplier-specific prices, it w i l l then purchase out to the point where m a r g i n a l revenue equals the m a r g i n a l cost, just c o v e r i n g the cost o f  suppliers become accustomed to the higher price. C o m p a r i s o n o f r o u n d w o o d and residual c h i p prices requires taking into account differences i n quality that may arise between the two different types o f chips. These differences stem from such factors such as species, chip geometry, and the relative proportion o f contaminants (bark, knots, etc.) w h i c h ultimately determine the quality. V a r i a t i o n between the two appears to be greater depending upon the specific producer rather than the specific process! In this case, r o u n d w o o d chips were selling at 5 0 % or greater premiums, w e l l outside the normal variation associated w i t h quality differentials. In U S markets, the two types o f chips are usually equivalent i n price. T h i s suggests that the use o f two-tier p r i c i n g i n the early 1970's i n the Interior, w h i c h paid a higher price for "incremental" volumes o f chips, differentiated between the relatively inelastic supply o f residual chips under " n o r m a l " conditions i o n o f chips, and the more elastic supply o f w o o d that c o u l d be obtained by u t i l i z i n g w o o d that was then currently being burned or put into landfills. However, the subsequent use of incremental prices i n later years was more l i k e l y to increase the production o f chips by c h i p p i n g low-grade lumber, as by this time the amount o f additional fibre that could be recovered at the m i l l was negligible. B i n k l e y notes the use o f special non-cash tickets used i n part to pay suppliers as a means o f preventing arbitrage.  59  c h i p p i n g and the transportation cost to that particular s a w m i l l . T h e m o d e l then y i e l d s a u n i f o r m s a w m i l l p r i c e w h i c h just covers the cost o f c h i p p i n g , and where increases i n d e m a n d l e a d to the u t i l i z a t i o n o f m o r e and m o r e distant producers f r o m s a w m i l l A t o s a w m i l l E (as seen i n F i g u r e 5). T h i s m o d e l i s discussed further i n C h a p t e r 3 .  T h e s e m o d e l s o f p u l p w o o d procurement assume f i r m s act as monopsonists and d o not incorporate interaction between f i r m s . B y turning to the broader literature i n v o l v i n g game theory and industrial organization it i s possible to f i n d a r i c h set o f m o d e l s , w h i c h incorporate market structure, f i r m interaction, and p r i c e d i s c r i m i n a t i o n .  Models  of Spatial  Pricing  and Market  Power  W h a t happens w h e n market p o w e r is translated into geographic space? T h e starting point f o r most m o d e l s is that o f a spatial m o n o p o l i s t . A single f i r m faces customers w i t h identical demands w h o are spatially dispersed (usually u n i f o r m l y a l o n g a l i n e segment for ease o f exposition) and there are positive transportation costs, so their net demands as seen b y the f i r m v a r y . T h e m o n o p o l i s t m a y choose to s i m p l y set their price at the factory gate and let customers arrange f o r transportation. If, however, the f i r m takes care o f d e l i v e r y and does not a l l o w the b u y e r to p i c k up the g o o d at the plant, then, the f i r m c a n practice a particular type o f third-degree price d i s c r i m i n a t i o n c a l l e d spatial price discrimination b y charging customers prices specific to their l o c a t i o n (net o f transportation costs). These prices w i l l be both a f u n c t i o n o f the distance between the customer and f i r m and the b u y e r ' s d e m a n d elasticity (this price i n c l u s i v e o f a l l costs is c o m m o n l y c a l l e d the delivered price). T h e price l e v e l or mill price (that is, the p r i c e at the f i r m ' s location) and the slope o f the d e l i v e r e d price schedule vary w i t h these parameters. A s d e m a n d becomes m o r e inelastic, the price l e v e l w i l l rise and the d e l i v e r e d price schedule w i l l flatten (these and the f o l l o w i n g results also h o l d true w h e n market p o w e r is o n the purchasing side).  72  72  V a r i a n (1989) shows that the delivered price depends o n both the first and second derivatives o f the demand function. W h e n the demand function is linear, the price increases by one-half o f the transportation cost, w h i l e i f demand is exponential (more elastic), the price w i l l increase by exactly the transportation cost. Perfectly inelastic demands w i l l lead to a firm choosing a price equal to the  60  F i g u r e 6 illustrates the d e l i v e r e d price schedule w h e n a f i r m i s setting prices for customers that are u n i f o r m l y distributed a l o n g a l i n e segment and have i d e n t i c a l d e m a n d curves. A s the f i r m takes care o f d e l i v e r y , the price the customer faces includes b o t h the cost o f the g o o d , C , and the transportation cost, t, to the customer's l o c a t i o n . S i n c e d e m a n d effectively falls w i t h distance (since m o r e distant customers are f a c i n g higher prices due to h i g h e r transportation costs), the f i r m takes this effect into account w h e n determining the delivered p r i c e . A s d e m a n d becomes less p r i c e elastic (decreases f r o m e l to e2), the f i r m w i l l raise the p r i c e l e v e l or m i l l p r i c e f r o m P l to P 2 , but decrease the slope o f the d e l i v e r e d price schedule. P r i c e d i s c r i m i n a t i o n increases, as measured b y the difference i n net realizations to the f i r m . I n these m o d e l s different spatial p r i c i n g systems 73 s i m p l y reflect different u n d e r l y i n g elasticities o f d e m a n d or supply.  A w e l l - k n o w n result i n welfare e c o n o m i c s i s that where a l l markets are perfectly competitive (and so price equals m a r g i n a l cost) the result i s a Pareto O p t i m u m . T h i s result c a n be extended into space, where prices equal the m a r g i n a l cost o f p r o d u c t i o n plus transportation costs to a c u s t o m e r ' s l o c a t i o n . T h i s type o f p r i c i n g , also k n o w n as FOB pricing, i s often used as a b e n c h m a r k for c o m p e t i t i v e prices (see, for e x a m p l e , m o d e l s by M o u g e o t 1 9 7 5 , T h i s s e 1 9 7 5 , and G r e e n h u t et a l . 1987). H o w e v e r , there are n o such clear-cut results for imperfect markets w h e n space becomes a factor. F O B p r i c i n g m a y or m a y not arise under c o m p e t i t i v e behavior, and cannot be u s e d as the sole criterion to establish whether a market is c o m p e t i t i v e or not ( P h l i p s 1983).  Instead,  competitiveness becomes a m o d e l - s p e c i f i c d e f i n i t i o n , dependent u p o n the assumptions o f the model.  O n e o f the w a y s the intensity o f c o m p e t i t i o n c a n be incorporated i n the analysis i s through different assumptions about the structure o f the market. T h e classic m o d e l incorporating market structure  customers' reservation values. Where these values are the same, this means the delivered price schedule w i l l be perfectly flat. 7 3  It should be noted that more elastic demands w i l l y i e l d delivered price schedules that vary by more than the transportation cost to that location (this is called phantom freight). S u c h results are usually ruled out arbitrarily by the invocation o f arbitrage so that prices w i l l then follow an F O B system. 61  Figure 5. Price Discrimination in a Wood Chip Market  and locational differences i s the spatial d u o p o l y m o d e l used b y H o t e l l i n g (1929) to study horizontal differentiation. I n the basic m o d e l , t w o f i r m s w i t h constant m a r g i n a l costs are located at opposite ends o f a l i n e segment. T h e f i r m s face customers u n i f o r m l y distributed a l o n g the l i n e segment between the t w o , where the customers have identical unit demands and i n c u r positive transportation costs i n traveling to either f i r m . T h e N a s h e q u i l i b r i u m y i e l d s prices based o n the f i r m s ' m a r g i n a l cost and transportation cost w i t h positive profits; h o w e v e r , i f transportation costs are zero the result is a Bertrand e q u i l i b r i u m w i t h m a r g i n a l cost p r i c i n g . W h e n both f i r m s are 7 4  located at the same point, the e q u i l i b r i u m i s again Bertrand w i t h zero profits and m a r g i n a l cost p r i c i n g regardless o f transportation costs. T h e m o d e l suggests that the competitiveness o f a market is determined b y the l o c a t i o n o f f i r m s , and that f i r m s m a y be able to enjoy profits even i n competitive markets. I n the case o f an o l i g o p s o n y , this suggests that c o m p e t i t i o n w i l l l e a d to higher prices w h e n firms are located coincidentally than w h e n they enjoy l o c a l m o n o p s o n i e s . T h e m o d e l does not s p e c i f i c a l l y address the issue o f different p r i c i n g systems.  Greenhut and Greenhut (1975) address the issue o f d e l i v e r e d p r i c i n g systems i n their m o d e l . F i r m s have constant m a r g i n a l costs and are located at the same endpoint o f a l i n e segment, w i t h customers w h o have i d e n t i c a l demands and w h o are u n i f o r m l y distributed a l o n g the l i n e segment. T h e f i r m s ' p r o b l e m is to then m a x i m i z e profits b y d e c i d i n g what d e l i v e r e d prices to set, w h e n f i r m s engage i n C o u r n o t conjectures about h o w the other firms w i l l react. T h e f i r m s take care o f a l l transportation and the delivered price includes a l l costs to the customer's l o c a t i o n . T h e slope o f the delivered price schedule c a n range between 0 and 1, where 1 means that the delivered price varies by the actual transportation cost, and 0, where a l l customers, regardless o f their l o c a t i o n , pay the same delivered price. W h e r e the price varies b y the actual transportation cost, this i s considered  FOB pricing, and w h e n the d e l i v e r e d p r i c e i s the same, this i s c a l l e d uniform delivered pricing (UDP). I f the delivered p r i c e is somewhat intermediate then freight absorption is taking place, i n  74  A Nash equilibrium is defined as the outcome when neither firm, given the other firms' actions, faces any reason to change its own actions (Tirole 1988). Games in which the firms' choice variables are prices are called Bertrand games; when quantities are the choice variable, they become Cournot games. In a Cournot game the market price is above the competitive level but below the below monopoly level. 63  the sense that g i v e n a c o m m o n m i l l price, the d e l i v e r e d p r i c e is less than the full 75  transportation cost to any customer.  T h e authors then show that as m o r e f i r m s enter the same  location, the m i l l p r i c e falls a n d the slope o f the d e l i v e r e d p r i c i n g schedule increases. A s the n u m b e r o f firms approaches infinity, the m i l l net p r i c e falls to m a r g i n a l cost a n d the slope o f the d e l i v e r e d p r i c e approaches the transportation cost. F i g u r e 7 illustrates h o w the m i l l p r i c e falls f r o m P l to P2 a n d the slope o f the d e l i v e r e d p r i c e schedule approaches actual transportation costs as the n u m b e r o f f i r m s increases (from N l to N2). In this m o d e l , i n c r e a s i n g c o m p e t i t i o n (as defined by the entry o f new f i r m s at the same location) leads to F O B p r i c i n g at m a r g i n a l cost, o r non-discriminatory pricing.  F o r an o l i g o p s o n y , F O B p r i c i n g i s the equivalent o f a u n i f o r m p r i c e at the purchaser's gate, w i t h each s u p p l i e r ' s net price differing by the transportation costs between their l o c a t i o n a n d the purchaser. T h e equivalence i n the case w i t h F O B p r i c i n g arises f r o m the fact that the f i r m perceives no difference i n any s u p p l i e r ' s costs, regardless o f the l o c a t i o n o f the supplier, w h i l e under F O B p r i c i n g the f i r m w o u l d see no difference i n the net revenue f r o m any customer, regardless o f the c u s t o m e r ' s l o c a t i o n . I n the m o d e l above, then, suppliers w o u l d r e c e i v e rents as prices increase and locational rents as the market becomes more competitive a n d prices m o v e towards a u n i f o r m p r i c e at the purchaser's gate w h e n firms are i n the same l o c a t i o n . Furthermore, price d i s c r i m i n a t i o n w i l l decrease as c o m p e t i t i o n increases.  Greenhut a n d G r e e n h u t (1975) then l o o k at the entry o f firms at the other endpoint o f the l i n e segment a n d assume that there is complete market overlap. In this case, the endpoint w i t h the greater n u m b e r o f firms determines the m i l l p r i c e a n d d e l i v e r e d p r i c e schedule. H o w e v e r , i f the n u m b e r o f firms at each l o c a t i o n is equal, then the d e l i v e r e d p r i c e schedule is perfectly horizontal (the same to any customer, regardless o f l o c a t i o n ) , a n d U D P prevails. A s the n u m b e r o f firms  7 5  T h i s term is somewhat misleading since the delivered price can be well i n excess o f the actual production and transportation cost, while the term is c o m m o n l y used to suggest that somehow costs are being absorbed b y the firm or b y one set o f customers at the expense o f another set. So l o n g as the delivered price exceeds a l l costs to any customer, the presence o f freight absorption simply reflects the ability o f firms to practice third-degree price discrimination.  64  Figure 6. More Inelastic Demand Leads to Greater Price Discrimination (E1>E2)  Distance  Figure 7. Increased competition from firm entry reduces price discrimination (N2>N1)  Distance F r o m G r e e n h u t a n d G r e e n h u t (1975)  65  increase, regardless o f their l o c a t i o n , prices m o v e towards a U D P system, so price d i s c r i m i n a t i o n is increasing. F i n a l l y , the authors l o o k at market areas that are o n l y p a r t i a l l y overlapped. I n this case, the delivered p r i c i n g schedule w i l l tend to be flatter i n the overlapped area where there are m o r e firms c o m p e t i n g (that i s , t e n d i n g t o w a r d s U D P ) .  F i g u r e 8 shows a k i n k i n  the d e l i v e r e d price schedule where there is market overlap between the N l f i r m s at one e n d o f the l i n e segment and the N2 firms at the other end (effectively, the n u m b e r o f firms serving this segment o f the market i s N l + N2).  U n d e r this m o d e l , increased c o m p e t i t i o n due to the presence  o f more firms w i t h i n that market area leads to a flatter price schedule and increased price discrimination.  In the case o f a n o l i g o p s o n y , then, m o v e m e n t towards a U D P p r i c i n g s y s t e m (where the net realization decreases b y the actual transportation costs) is the equivalent o f purchasers m o v i n g towards p a y i n g a u n i f o r m p r i c e to the suppliers ( U S P ) (where the total costs increase b y transportation costs). G i v e n a c o m m o n p r i c e across suppliers, then, the a v a i l a b l e rents depend o n l y o n the price l e v e l and not o n l o c a t i o n . T h i s m o d e l suggests that w h e n firms are spatially separated increasing c o m p e t i t i o n w i l l lead to increasing price d i s c r i m i n a t i o n .  N o r m a n (1981) has also offered several m o d e l s i n w h i c h the degree o f spatial price d i s c r i m i n a t i o n relies o n the amount o f c o m p e t i t i o n . I n one m o d e l , spatial p r i c e d i s c r i m i n a t i o n i s greater w h e n t w o coincidentally-located oligopolists c o l l u d e , w h i l e c o l l u s i o n between n o n - c o i n c i d e n t a l l y located o l i g o p o l i s t s leads to m o r e ambiguous results. I n another m o d e l , the firm chooses a linear p r i c i n g pattern, subject to the constraint o f a c e i l i n g or spatial l i m i t price, where this l i m i t price reflects c o m p e t i t i v e conditions and the potential entry o f new firms, and where customers have i d e n t i c a l demands. I f the spatial l i m i t p r i c e i s not b i n d i n g , the firm acts as a spatial m o n o p o l i s t , c h o o s i n g the price at each l o c a t i o n that equates m a r g i n a l revenue and m a r g i n a l cost ( w h i c h is i n c l u s i v e o f the transportation cost). T h e slope o f the d e l i v e r e d p r i c i n g schedule w i l l then v a r y , depending o n the elasticity o f the i n d i v i d u a l demands, as i n Greenhut and G r e e n h u t (1975). H o w e v e r , as the spatial l i m i t price becomes b i n d i n g , the firm m o v e s towards greater p r i c e d i s c r i m i n a t i o n , eventually  Figure 8. Increased competition from overlapping market areas leading to increased price discrimination  P2  N2 Distance  Market overlap between N1 and N2 From Greenhut and Greenhut (1975)  67  establishing a u n i f o r m delivered p r i c i n g p o l i c y w h e n the l i m i t price binds over the entire market area.  These m o d e l s s h o w that the relationship the o p t i m a l p r i c i n g system m a y depend o n a variety o f factors: the degree o f concentration (as expressed i n the n u m b e r o f f i r m s ) ; d e m a n d or supply elasticities; and the l o c a t i o n o f firms. Furthermore, the presence or absence o f d i s c r i m i n a t o r y p r i c i n g arrangements cannot be used to establish the competitiveness o f a market. Profitm a x i m i z i n g firms c a n m o v e towards either F O B p r i c i n g or U D P as c o m p e t i t i v e pressures b e c o m e stronger, d e p e n d i n g o n the structure o f the market and other assumptions. T h e same result carries o v e r into a n o l i g o p s o n y setting; depending o n the market structure (e.g. the n u m b e r o f firms and/or their location), increasing c o m p e t i t i o n c a n lead to either u n i f o r m prices at the purchaser's l o c a t i o n or the s u p p l i e r ' s . W e are then left w i t h the rather i n c o n c l u s i v e result N o r m a n (1981) notes:  " T h e existence o f spatial price d i s c r i m i n a t i o n i n particular markets is not a priori evidence of l a c k o f c o m p e t i t i v e pressures. B u t neither c a n a s i m p l e c o n n e c t i o n be d r a w n between the degree o f c o m p e t i t i o n and the degree o f spatial price d i s c r i m i n a t i o n . D i s c r i m i n a t i o n between spatially separated consumers...may indeed reflect and be the result o f intense competitive pressures i n particular markets, but this i s m o r e l i k e l y i f the competitors i n such markets are not themselves spatially concentrated. O n the other hand, d i s c r i m i n a t i o n m a y be the consequences o f c o l l u s i v e agreements between c o i n c i d e n t a l l y located producers, o r o f attempts b y such producers to anticipate the actions o f their competitors."  Delivered  Pricing  Systems  O n e reason the issue o f spatial price d i s c r i m i n a t i o n has received so m u c h attention is that spatial variations i n p r i c i n g are observed i n a variety o f markets. A c o m m o n practice for m a n y industries where transportation costs can be significant has been the use of delivered pricing systems. T h e s e systems calculate e x p l i c i t spatial prices a c c o r d i n g to some specific f o r m u l a e m p l o y e d b y sellers i n the industry. T h e s e type o f systems have received considerable e c o n o m i c attention over the years. S o m e authors have noted that d e l i v e r e d p r i c i n g systems, by a l l o w i n g the p o s s i b i l i t y o f setting customer or supplier-specific prices, c a n l e a d to higher profits. T h i s p o s s i b i l i t y m a y support m o r e c o l l u s i v e behavior as firms perceive the benefit f r o m c o o r d i n a t i n g prices. Other authors have countered that such systems instead reflect competitive forces and s i m p l y show h o w firms meet  68  c o m p e t i t i o n o n a spatial basis. These systems m a y o r not m a y d i s p l a y spatial p r i c e d i s c r i m i n a t i o n , depending u p o n the formulas i n v o l v e d .  O n e example o f a delivered p r i c i n g system is a basing point system ( B P ) . I n a b a s i n g p o i n t system, the price d e l i v e r e d to the customer's d o o r i s calculated as a c o m m o n price at some particular f i x e d point (the base price), plus the notional transportation costs f r o m that p o i n t to the customer's l o c a t i o n . Consequently, a l l f i r m s charge the same identical d e l i v e r e d price to a 76  particular customer's l o c a t i o n , regardless o f any one seller's l o c a t i o n . I n one v a r i a t i o n , there m a y be m u l t i p l e basing points, and firms m a y practice alignment, f o l l o w i n g specific rules about w h i c h prices a p p l y .  77  U n d e r s t a n d i n g the e c o n o m i c reasons f o r these types o f systems has been the j u s t i f i c a t i o n f o r m u c h o f the w o r k done o n d e l i v e r e d p r i c i n g schemes a n d especially basing point systems (see Fetter 1937, M a c h l u p 1949, L o e s c h e r 1959, Scherer 1980, a n d G i l l i g a n 1992 f o r various studies). B a s i n g point systems were c o m m o n i n the U n i t e d States i n the early part o f the century, until the Federal T r a d e C o m m i s s i o n f o u n d such schemes lessened c o m p e t i t i o n ( E s p i n o s a 1992). E m p i r i c a l w o r k b y G r e e n h u t , Greenhut, a n d L i (1980) has suggested that m a n y h i g h l y concentrated industries w i t h a h i g h degree o f spatial differentiation such as cement, steel, a n d c o r n , d i d use d e l i v e r e d p r i c i n g schemes i n the U S . S t i g l e r (1949) offers instances where cartelization c o i n c i d e d 78  w i t h the d r o p p i n g o f a n F O B p r i c i n g system a n d the introduction o f a d e l i v e r e d p r i c i n g system. Stigler (1964) e x a m i n e d basing point systems a n d suggested they m a y be m o r e l i k e l y to arise i n industries where d e m a n d w a s geographically unstable (for e x a m p l e steel a n d cement). I n his v i e w , b a s i n g point systems offered a n o r d e r l y w a y f o r f i r m s to extend their sales area w h e n they f o u n d d e m a n d w a s l o w w i t h i n their area without the r i s k o f precipitating price cuts. H e noted that the system, w h i l e p r o v i d i n g a n outlet f o r some f i r m s , tended to reduce the attractiveness o f m o r e 7 6  T h e classic basing point system examined i n the economic literature was the "Pittsburgh p l u s " system that expressed steel prices as the price o f steel i n Pittsburgh delivered to a particular location, even i f the steel was supplied b y a m i l l somewhere other than i n Pittsburgh.  7 7  One c o m m o n rule is that the lowest delivered price should apply.  78  T h i s happened i n both the German cement industry a n d the B r i t i s h bituminous coal industry.  69  distant markets. L e u s c h n e r (1952) also s h o w e d h o w a b a s i n g p o i n t system through the use o f p u n i t i v e bases c o u l d be used to p u n i s h a firm that deviated f r o m the system.  D u e to differences i n antitrust l a w , d e l i v e r e d p r i c i n g systems are m o r e c o m m o n i n E u r o p e . P h l i p s (1981) discusses the use o f u n i f o r m d e l i v e r e d prices i n t w o markets where firms h o l d market p o w e r . T h e first case i s that o f B r i t i s h Plasterboard, w h i c h has a m o n o p o l y i n the U n i t e d K i n g d o m , and sells plasterboard at a u n i f o r m d e l i v e r e d p r i c e throughout the country. T h e second example is that o f B e l g i u m , where a cartel o f cement producers charge the same delivered price throughout the country regardless o f l o c a t i o n o f the b u y e r relative to the closest plant.  H a d d o c k (1982) offered an alternative v i e w o f d e l i v e r e d p r i c i n g systems, arguing that b a s i n g p o i n t schemes c a n emerge i n competitive markets as the result o f different cost structures for firms at different locations. G i l l i g a n (1992) argued that b a s i n g point systems reflected c o m p e t i t i o n a m o n g firms located at the basing point, w h i l e firms elsewhere used the basing p o i n t system to a l i g n their prices w i t h their rivals. T h i s s e a n d V i v e s (1988), h o w e v e r , s h o w e d that b a s i n g p o i n t p r i c i n g o n l y emerges as the outcome o f a non-cooperative game w h e n one firm chooses a sub-optimal strategy (this m o d e l i s discussed m o r e f u l l y i n C h a p t e r 3).  E s p i n o s a (1992) argues that i d e n t i c a l u n i f o r m d e l i v e r e d p r i c i n g systems c a n be very c o m p e t i t i v e . W h e n a l l firms are c h a r g i n g the same p r i c e , any change i n one firm's price c a n cause a dramatic change i n its market area and hence the other firms' market area. C o m p a r e d to a F O B p r i c i n g system, where the effect o f a change i s l i k e l y to be m o r e l o c a l i z e d , this greater degree o f interpenetration means that such a system c a n lead to far m o r e competitive behavior. E s p i n o s a (1992) b u i l t s u c h a m o d e l to e x a m i n e the relationship between market structure, p r i c i n g systems, and changes i n competitive behavior, and showed that competitive markets c a n have either u n i f o r m d e l i v e r e d prices or F O B prices depending o n the l o c a t i o n o f firms. Furthermore, the degree o f c o m p e t i t i o n , and the type o f system, depend o n exogenous variables s u c h as firm's discount rates, transportation costs, and customers' reservation values, and firms w i l l s w i t c h between the t w o different p r i c i n g systems as these variables change (this m o d e l i s also discussed m o r e f u l l y i n  70  C h a p t e r 3 ) . E s p i n o s a (1992) offered the observation that after the U . S . S u p r e m e C o u r t o u t l a w e d basing-point p r i c i n g systems i n 1948, both the cement and steel industries m o v e d to a n F O B p r i c i n g system and b o t h prices and revenues increased i n e a c h industry.  She suggests that i n  this case the delivered p r i c i n g system facilitated c o m p e t i t i o n , and that b y d r o p p i n g i t such competitive pressures were eased, although she does not p r o v i d e any detailed e m p i r i c a l data to support s u c h a c o n c l u s i o n .  D u e r r (1994) notes that i n the U S S o u t h , after W W I I , p u l p and paper m i l l s m o v e d f r o m a u n i f o r m d e l i v e r e d p r i c i n g system for purchasing p u l p w o o d to a system where m i l l s set prices so that they were u n i f o r m across a l l suppliers ( w h i c h he c a l l s local pricing). D u e r r attributes the change to increased c o m p e t i t i o n , as the number o f p u l p m i l l s i n the area increased, although he does not p r o v i d e any theoretical justification.  E s p i n o s a ' s (1992) m o d e l incorporates the issue o f f i r m interaction i n a spatial context that i s m i s s i n g f r o m the p r e v i o u s static m o d e l s i n t r o d u c e d . I n d o i n g so, she s h o w s that f i r m s , through r e c o g n i z i n g their interdependence, m a y be able to sustain payoffs different than those under c o m p e t i t i v e assumptions through c h a n g i n g their responses to one another's actions. H o w these (  firms alter their responses, then, raises the issue o f what factors m a y influence f i r m b e h a v i o u r , as w e l l as the idea that observed p r i c i n g systems m a y reflect something m o r e than the u n d e r l y i n g market structure.  Firm  Behaviour  and the Effect  on Market  Outcomes  E c o n o m i s t s ' m a i n concern over o l i g o p o l i e s stemmed i n i t i a l l y f r o m f i r m s acting i n a coordinated fashion to sustain m o n o p o l y prices through cartels o r other p r i c e - f i x i n g agreements. S u c h overt c o l l u s i o n was c o m m o n i n N o r t h A m e r i c a i n the early part o f the century, but due to their a n d competitive nature m a n y o f the practices f i r m s e m p l o y e d were eventually outlawed.  7 9  79  Chamberiin  There are a variety o f cases. One o f particular interest was the investigation i n 1956 o f p u l p w o o d procurement i n Eastern Canada. A R o y a l C o m m i s s i o n found that p u l p w o o d buyers (mainly domestic pulp mills) had agreed o n both prices and pricing practices. A c o n v i c t i o n was obtained  71  (1929) was the first to suggest that f i r m s , through their r e c o g n i t i o n o f their m u t u a l interdependence, m i g h t still act i n such a w a y as to sustain the m o n o p o l y price without necessarily cooperating overtly. A l t h o u g h firms w o u l d still engage i n non-cooperative behavior, their recognition o f the nature o f the market m i g h t be sufficient to deter t h e m f r o m competitive behavior. F o r e x a m p l e , a f i r m w o u l d realize l o w e r prices m i g h t i n i t i a l l y l e a d to greater market share for one f i r m , temporarily r a i s i n g profits, but u l t i m a t e l y w o u l d y i e l d a p r i c e w a r that w o u l d depress a l l f i r m s ' profits, i n c l u d i n g its o w n . Therefore, a l l the f i r m s i n the industry w o u l d m u t u a l l y refrain f r o m l o w e r i n g the price, and i n d o i n g so raise their l o n g - r u n payoffs above the m i n i m u m l e v e l . S u c h outcomes are said to be tacitly collusive. A s P h l i p s ( 1 9 8 1 ) states,  " . . i n a l e g a l environment where e x p l i c i t p r i c e agreements are not enforceable, so that j o i n t profit m a x i m i z a t i o n is not a possibility, o l i g o p o l i s t s are supposed to replace e x p l i c i t agreements b y "tacit c o l l u s i o n " i n the standard antitrust literature. T h e s e tacit agreements are supposedly reached through a n exchange o f i n f o r m a t i o n o n prices, sales c o n d i t i o n s , and possibly other relevant data such as p r o d u c t i o n data and investment projects." P h l i p s (1981) then points out that d e l i v e r e d p r i c i n g systems c a n also facilitate c o l l u s i v e outcomes.  Of)  Factors that Influence Firm Behaviour Scherer (1980) outlines a n u m b e r o f factors that c a n a i d or hinder c o l l u s i o n . These i n c l u d e : the number and size distribution o f sellers; product heterogeneity; cost structures; l u m p i n e s s and infrequency o f orders; secrecy and retaliation lags; and industry s o c i a l structure. A l l o f these point to the t w o central issues. H o w easily c a n f i r m s coordinate their actions to raise payoffs, and i f f i r m s are successful i n r a i s i n g payoffs, h o w c a n defection (or cheating) be discouraged?  under the Combines Investigation A c t i n 1960 (see R e g i n a v. A b i t i b i P o w e r & Paper C o . L t d . 1960). ' T h e adoption o f a particular pricing technique may, i n a spatial framework, have direct implications for the probability o f detecting deviating behaviour and thus for the ease w i t h w h i c h e q u i l i b r i a are f o u n d and maintained." ( P h l i p s 1981:46)  72  Scherer (1980) noted that few sellers (or buyers) eases c o l l u s i o n b y r e d u c i n g the n u m b e r o f potential players to coordinate and monitor, and also m a k e s the effect o f their o w n actions m o r e ' obvious.  8 1  In addition, product homogeneity means that a l l f i r m s ' goods are s i m i l a r , and b y s t r i p p i n g a w a y other attributes, it leaves p r i c i n g as the o n l y issue to be r e s o l v e d . B y f o c u s i n g o h o n l y one aspect, it reduces the c o o r d i n a t i o n p r o b l e m b y both r e d u c i n g the c o m p l e x i t y o f the p r o b l e m as w e l l as m a k i n g it easier it is to identify w h e n price concessions are g i v e n . Scherer (1980) identifies four classes o f heterogeneity, one a p p l i c a b l e i n a spatial context. T h a t i s w h e n products are differentiated b y transportation costs, and Scherer (1980) refers to the literature o n basing point systems as a means o f addressing that heterogeneity.  T h e t h i r d factor i s cost structure. Scherer (1980) argues that firms w i t h h i g h fixed costs w i l l be m o r e l i k e l y to deviate because i n periods o f h i g h d e m a n d , f a l l i n g average costs are an added benefit to increased p r o d u c t i o n .  T h e frequency o f orders i s l i k e l y to determine h o w often firms interact. If, f o r e x a m p l e , there are large infrequent orders, firms m a y be m o r e i n c l i n e d to compete f o r them than i f there was a m o r e e v e n f l o w o f orders.  Secrecy is the critical factor i n determining whether or not a c o l l u s i v e arrangement i s sustainable. If firms are unable to m o n i t o r or determine w h e n a participant i s d e v i a t i n g f r o m the system, the l i k e l i h o o d o f such a d e v i a t i o n is increased. Furthermore, firms m a y have difficulty d i s t i n g u i s h i n g between natural uncertainty and uncertainty about firm behavior. F o r e x a m p l e , does unexpectedly l o w d e m a n d f o r one firm signal that another is undercutting it or that d e m a n d has temporarily dropped?  81  ' T h e number o f two-way c o m m u n i c a t i o n flows required is g i v e n by the combinatorial expression N ( N - l ) / 2 ; that is, for t w o sellers, the number o f channels is one; w i t h six, it rises to 15, and so o n . " (Scherer 1980: 200)  73  A l o n g w i t h secrecy, retaliation lags are also a factor. M u c h l i k e infrequent orders, i f a f i r m feels that any punishment for d e v i a t i n g is "far e n o u g h " a w a y , it m a y not f i n d the proposed punishment sufficient to deter it f r o m cheating.  F i n a l l y , Scherer (1980) suggests that industry s o c i a l structure m a y be important as w e l l . A l t h o u g h economists u s u a l l y shy a w a y f r o m anything that m a y i n v o l v e personal attributes, Scherer (1980) suggests that certain social structures m a y be m o r e c o n d u c i v e to c o l l u s i v e behavior. F o r e x a m p l e , participants m a y b e l o n g to the same social setting, and social stigma m a y attach to a n y b o d y that appears to be d e v i a t i n g f r o m industry n o r m s .  Spence (1978) has offered a m o d e l that examines a w e a k e r f o r m o f tacit c o l l u s i o n w h i c h he terms tacit coordination. T h e information required to determine whether f i r m s m a y be deviating f r o m any k i n d o f market-sharing or price setting agreement c a n be f o r m i d a b l e . Spence has b u i l t a m o d e l w i t h i n c o m p l e t e i n f o r m a t i o n , where f i r m s receive signals about one anothers' actions m a s k e d b y noise (a r a n d o m v a r i a b l e i n the m o d e l ) . F i r m s choose strategies based o n the signals they receive that j o i n t l y m o v e them towards the profit frontier and a w a y f r o m the less profitable C o u r n o t - N a s h e q u i l i b r i u m . I n the m o d e l , the scope a n d profitability o f tacit coordination increase as the signal b e c o m e s less n o i s y and the less profitable the profits w h e n b e i n g punished.  T h e factors described by Scherer (1980) also h o l d true i n S p e n c e ' s m o d e l . T o the extent f i r m s c a n m i n i m i z e the noise or restrict the i n f o r m a t i o n required to m o n i t o r one another's behavior, they w i l l be m o r e successful i n r a i s i n g profits above the non-cooperative outcome.  Empirical  Investigations  of Noncompetitive  Behavior  M a n y o f these factors m a y be quantified to test f o r c o l l u s i v e behavior. T h i s approach, first pioneered b y B a i n (1956) and k n o w n generally as the Structure-Conduct-Performance ( S C P )  74  p a r a d i g m , emphasizes variables such as the n u m b e r and relative size o f industry participants to investigate the competitiveness o f markets as w e l l as r e l y i n g o n extensive market studies.  Measures o f noncompetitive behavior usually examine the premise that c o l l u s i v e behavior w i l l raise f i r m s ' profits relative to more competitive outcomes. M u c h research has been a i m e d at e x a m i n i n g what factors m a y affect h o w f i r m s conduct their business and the resulting i m p a c t o n the competitiveness o f the market. A s pointed out above, since the presumed goal o f n o n competitive behavior is to raise profits above competitive l e v e l s , the most direct approach w o u l d be to measure profits directly as a test o f c o m p e t i t i v e behavior. H o w e v e r , there are a n u m b e r o f e m p i r i c a l problems associated w i t h u s i n g p u b l i c l y reported profit statements, such as differences between a c c o u n t i n g requirements and theoretical constructions o f what profits consist of, m a i n l y h a v i n g to do w i t h the appropriate treatment o f capital. Despite this difficulty, there is a considerable amount o f w o r k i n this area.  A n o t h e r approach is to s i m p l y e x a m i n e p r i c e l e v e l s , under the assumption that, ceteris paribus, f i r m s use higher prices to obtain h i g h e r profits. T h e explanatory variables i n turn tend to be those measures, such as f i r m size and concentration, that are thought to be important determinants i n c o l l u s i v e behavior and are usually available. A n e x a m p l e o f such w o r k i s W e i s s et. a l . ( 1 9 8 9 ) , w h i c h shows h o w concentration w i t h i n r e g i o n a l markets leads to higher prices i n the cement industry.  T h e r e is a potentially tautological question that has to be addressed i n f r a m i n g these types o f investigations. G i v e n that the m a i n objective o f c o l l u s i o n is to lessen c o m p e t i t i o n , thereby l e a d i n g to higher profits, does that m e a n that higher profits m e a n c o l l u s i o n ? D e m s e t z (1968) has made the point that m o r e successful firms w o u l d tend to have h i g h e r market shares than less successful firms, therefore l e a d i n g to a correlation between market shares and profits. T h e r e m a y be other factors that support higher profits, such as successful t e c h n o l o g i c a l i n n o v a t i o n at the firm l e v e l , w h i c h i n turn m a y be correlated w i t h firm size. Therefore, h i g h e r profits i n a n d o f themselves m a y not necessarily be i n d i c a t i v e o f non-competitive behavior. 75  A n o t h e r difficulty w i t h these approaches is that the tests require some benchmarks for c o l l u s i v e behavior. B e c a u s e the data tends to be aggregated, these measures are u s u a l l y either crosssectional across industries, or o n a t i m e series b a s i s .  82  E a c h o f these approaches raises its o w n set  o f problems. A g g r e g a t i o n requires that a l l firms respond i n the same manner, w h i l e cross-industry and time series comparisons require that the data be adjusted f o r any industry differences that m a y not be due to market p o w e r .  83  M u c h o f this w o r k provides little i f any institutional detail, and  often provides n o m e c h a n i s m s b y w h i c h non-competitive outcomes are sustained.  A n approach that has b e c o m e increasingly p o p u l a r has been to note that i f firms are engaged i n competitive behavior then price w i l l be greater than m a r g i n a l cost. E c o n o m i c theory c a n then be used to relate the difference to the u n d e r l y i n g d e m a n d or supply elasticity and market p o w e r ( D i e w e r t 1971). T h i s research offers the advantage o f not h a v i n g to rely o n c o m p a r i s o n s across different industries but instead l o o k s for deviations between m a r g i n a l cost and price i n what i s k n o w n as the New Empirical Industrial Organization ( N E I O ) approach. A p p l e b a u m (1979) shows h o w i n an o l i g o p o l y firms w i l l set the price equal to the m a r g i n a l cost plus a factor representing their perception o f h o w their actions affect market quantities. T h i s perception is based o n their expectations o f h o w other firms w i l l react to changes i n the firm's o w n actions, and the factor i s c o m m o n l y termed the conjectural variation. It c a n be s h o w n that this factor, or 0, is b o u n d e d  between 0 and 1, and under the competitive market assumption o f price t a k i n g 0=0, w h i l e under a  pure m o n o p o l y 0=1. Tests for the exercise o f m a r k e t p o w e r then consist o f whether or not 0 i s significantly different f r o m zero.  Because much industry data tends to be national i n scope, w h i c h masks regional variations, comparisons are then made across industries w h i c h typically requires adjusting the data to account for differences between industries. For example, price-cost margins are a c o m m o n tool used to test for market power. However, firms with high fixed costs tend to have high margins, especially i f the data is based o n cash manufacturing costs, and any comparisons may y i e l d spurious results unless the data is adjusted to reflect this fact.  76  A p p e l b a u m derived the factor 0 under spaceless c o n d i t i o n s . B r e s n a h a n ( 1 9 8 1 ) , i n h i s w o r k o n the a u t o m o b i l e industry, used a H o t e l l i n g f r a m e w o r k to m o d e l product differentiation. T h e derivation o f 6 i n this case has a c o m p o n e n t due to h o w different the product is f r o m other f i r m s ' products, w h i c h is d i r e c t l y analogous to spatial differentiation. M u r r a y (1996) used this f r a m e w o r k to derive a 6 that i s e x p l i c i t l y due to spatial distances, a n d tested for market p o w e r i n s a w l o g and p u l p w o o d markets i n the U S f o r the p e r i o d 1958 to 1988. M u r r a y finds that although the n u l l hypothesis cannot be rejected for s a w l o g markets, it i s rejected f o r three o f the five periods e x a m i n e d f o r the p u l p w o o d market. B e r n s t e i n (1992) p r o v i d e d a s i m i l a r e x a m i n a t i o n f o r the forest industry i n C a n a d a , and rejects the hypothesis that there has been any n o n c o m p e t i t i v e b e h a v i o r i n the forest industry i n C a n a d a i n either input or output markets.  T h i s a p p r o a c h has its o w n set o f p r o b l e m s . T h e m a i n benefit o f this approach c o m e s f r o m the fact that b y e m b e d d i n g 6 i n a system o f equations d e v e l o p e d under the standard theoretical assumptions governing factor d e m a n d , the efficiency o f the estimates are thereby increased, w h i l e the incorporated factor meets the consistency properties associated w i t h such d e m a n d equations ( c o n v e x i t y a n d h o m o g e n e i t y ) . T h e r e are, h o w e v e r , several problems w i t h the estimation o f m a r g i n a l cost. T h e first i s that the detailed data required f o r such estimation is u s u a l l y available o n l y o n an aggregated basis. A l t h o u g h the difficulties o f data aggregation c a n be theoretically handled (usually by a s s u m i n g a l l f i r m s are the same), firm l e v e l differences are w i p e d out. M i s specification m a y l e a d to inaccurate estimation. A s a case i n point, M u r r a y (1996) provides a s i m p l e e x a m p l e o f a spatial monopsonist to show h o w distance c a n be a factor i n the competitiveness o f the market. H e then uses fuel costs and a quadratic measure o f capacity to construct 6, arguing that increasing capacity and/or decreasing transportation costs s h o u l d b r i n g f i r m s i n t o increasing contact as their woodsheds expand, thereby l e a d i n g to increasing c o m p e t i t i o n . A closer e x a m i n a t i o n o f M u r r a y ' s result s h o w s that 6 was at its highest point i n the p e r i o d 19586 2 , and then subsequently f e l l i n each succeeding four year p e r i o d w i t h the t w o l o w e s t estimates  77  c o v e r i n g 1973-77 a n d 1978-82, w h e n 6 i s not statistically distinguishable f r o m 0. H i s measure o f market p o w e r then rose again i n the last measured p e r i o d to a l e v e l greater than any measured since 1967.  M u r r a y (1996) argues that this pattern o f decreasing and then increasing market p o w e r reflects the i n c r e a s i n g and then d e c l i n i n g use o f w o o d c h i p s , a r g u i n g that p u l p m i l l s enjoy less p o w e r i n p r i c i n g w o o d chips than they d o p u l p w o o d . H o w e v e r , there i s a m u c h m o r e p l a u s i b l e explanation w h i c h lies i n the treatment o f capital stocks. M u r r a y treats the capital stock as a n exogenous variable. Furthermore, instead o f u s i n g actual capacity, M u r r a y uses annual p r o d u c t i o n . A potential p r o b l e m then lies i n the fact that the o n l y place capacity (actual production) enters directly into the estimation is i n the construction o f the market p o w e r measure (as it i s a quadratic measure o f capacity). Therefore, M u r r a y ' s measure o f market p o w e r m a y s i m p l y be reflecting the correlation between h i g h rates o f p r o d u c t i o n associated w i t h h i g h market prices, rather than the exercise o f market p o w e r . T h i s seems especially plausible g i v e n that M u r r a y finds that market p o w e r ' v a n i s h e s ' d u r i n g the periods o f m a r k e t recession.  B r e s n a h a n and S u s l o w (1989) p r o v i d e another explanation as to w h y measures o f m a r k e t p o w e r based o n output or capacity u t i l i z a t i o n m a y produce spurious results. T h e y e x a m i n e d the a l u m i n u m market i n the U n i t e d States, a n d h y p o t h e s i z e d that i n the short r u n f i r m s face constant m a r g i n a l costs until practical capacity i s reached, p r o v i d i n g a b a c k w a r d - f a c i n g L - s h a p e d supply c u r v e (see  Figure 9).  U n d e r this hypothesis, w h e n capacity constraints are slack for the d e m a n d  curve Ds, m a r k e t p o w e r is greatest and the f i r m sets a price i n excess o f m a r g i n a l cost, where  Ps>C.  W h e n capacity constraints b i n d under d e m a n d conditions  Dc, a n d  the f i r m w i s h e s to  operate at m a x i m u m capacity, there is n o difference between the price the f i r m w o u l d choose versus the c o m p e t i t i v e p r i c e , Pc. T h e capacity constraint i s then reflected i n the opportunity cost o f capital ( w h i c h is the equivalent o f the forgone production, or the difference between the intersection o f the d e m a n d curve, Pc, a n d the constant m a r g i n a l costs o f p r o d u c t i o n , C).  They  78  Figure 9. Pricing with and without capacity constraints  from B r e s n a h a n a n d S u s l o w (1989)  79  then estimate t w o cost functions, one under slack conditions and one operating under the assumption o f capacity constraints and show that market p o w e r , greatest d u r i n g periods o f slack demand, has been f a l l i n g over time (they e x a m i n e d a thirty year period).  T h e s e results suggest that i m p r o p e r specification o f the cost curve m a y l e a d to an overestimation o f market p o w e r i f the f o r m u l a t i o n o f the p r o b l e m does not take into account the effects o f possible capacity constraints. These type o f m a r g i n a l cost curves are u s u a l l y associated w i t h capitalintensive industries, w h i c h i n turn tend to be those industries where there are r e l a t i v e l y few  firms.  T h i s then suggests that one s h o u l d be extremely careful i n u s i n g measures o f output, capacity u t i l i z a t i o n , or concentration ratios i n constructing measures o f market p o w e r . M u r r a y ' s results m a y s i m p l y reflect the influence o f capacity constraints a n d not market power, g i v e n that the profit function estimated does not distinguish between periods where capacity constraints m a y be a factor ( w h i c h i s a characteristic feature o f the p u l p and paper industry). T h i s m a y offer a n alternative explanation as to w h y M u r r a y ' s measures o f market p o w e r f a l l to near i n s i g n i f i c a n c e during the recessionary periods o f the 1970's and 1980's as capacity constraints w e r e not b i n d i n g d u r i n g those periods. M u r r a y also finds his measure o f market p o w e r to be s i g n i f i c a n t l y less i n the s a w l o g market. It m a y be the case that this s i m p l y reflects the fact that the s a w m i l l industry is less capital intensive than the p u l p and paper industry and that capacity constraints are not a factor.  A l o n g the same lines, B e r n s t e i n (1992) provides a n interesting contrast, h a v i n g estimated a s i m i l a r m o d e l for a C a n a d i a n data set. H i s approach is somewhat different i n that he a l l o w s firms to have face adjustment costs for quasi-fixed factors so that short-run m a r g i n a l costs m a y e x c e e d l o n g - r u n m a r g i n a l costs. U n d e r such circumstances, f i r m s w i l l not be i n l o n g - r u n e q u i l i b r i u m , and the fact that prices exceed l o n g - r u n m a r g i n a l costs reflects not the exercise o f market p o w e r but rather the presence o f these adjustment costs. B e r n s t e i n finds n o evidence o f market p o w e r i n either the s o l i d w o o d or p u l p and paper industry i n either output or input markets, but that each industry i s characterized b y substantial capital adjustment costs. A g a i n , B e r n s t e i n relies o n annual data at the national l e v e l .  80  H u n t e r (1982) a n a l y z e d p u l p w o o d stumpage a n d d e l i v e r e d prices i n the Southeastern U S a n d shows that p u l p w o o d stumpage prices are p o s i t i v e l y correlated w i t h the n u m b e r o f bidders w i t h i n 100 m i l e s , a n d notes that a l l prices generally decrease m o v i n g i n l a n d f r o m the A t l a n t i c Coast. A l t h o u g h he i n c l u d e d the n u m b e r o f bidders as i n d i c a t i v e o f c o m p e t i t i v e pressures, he also noted that the n u m b e r o f potential bidders m a y be a p r o x y f o r distance. H u n t e r d i d not m a k e any attempt to analyze potential c o m p e t i t i v e pressures, a n d v i e w e d the decrease i n p r i c e levels as one m o v e s i n l a n d representing general changes i n species a v a i l a b i l i t y a n d l a n d use patterns. A n alternative hypothesis c o u l d be that transportation costs increase as one m o v e s i n l a n d (due to the h i g h e r costs associated w i t h t r u c k i n g a n d r a i l relative to ocean transport), w h i c h l o w e r s the n u m b e r o f potential buyers a n d effectively decreases c o m p e t i t i o n .  F i n a l l y , there is a m u c h s m a l l e r set o f cases where the circumstances have lent themselves to m o r e detailed analysis, a n d the i m p a c t o f changes i n the regulatory environment c a n be quantified. A s c h et a l . (1992) p r o v i d e a n e x a m i n a t i o n o f the dairy industry w i t h a clear change i n government p o l i c y , a n d use the price differential between t w o classes o f m i l k as a measure o f c o l l u s i v e b e h a v i o r to show the i m p a c t o f the change o n f i r m b e h a v i o u r . Fraas a n d G r e e r (1977) u s e d a n u m b e r o f cases where the Federal T r a d e C o m m i s s i o n ( F T C ) investigated n o n - c o m p e t i t i v e behavior (as defined b y f o r m a l investigations) to measure factors other than concentration ratios that were important i n supporting c o l l u s i v e outcomes.  Studies of Spatial Price Discrimination E m p i r i c a l studies o f spatial price d i s c r i m i n a t i o n suffer f r o m m a n y o f the difficulties o u t l i n e d above. D a t a tends to be aggregated, r e q u i r i n g c o m p a r i s o n s across regions a n d industries that m a y not incorporate a l l factors. M u c h o f the w o r k has r e l i e d o n results f r o m s i m p l e m o d e l s o f spatial m o n o p o l i e s to argue that any d e v i a t i o n between prices a n d m a r g i n a l cost p l u s transportation costs represents the exercise o f market p o w e r . T h e magnitude o f the d e v i a t i o n is then used to quantify the degree o f market power. H w a n g (1979) provides a n e x a m p l e o f this approach, u s i n g the  81  difference between d e l i v e r e d prices and actual transportation costs i n the p r i c i n g o f coal i n the U S to measure the degree o f market p o w e r i n various markets.  G r e e n h u t et a l . (1980) a n d Greenhut et a l . (1981) p r o v i d e e m p i r i c a l investigations o f spatial p r i c i n g p o l i c i e s and test factors outlined earlier thought to be important i n determining the competitiveness o f spatial markets (such as l o c a t i o n , the n u m b e r o f competitors, and the nature o f demand). These results suggest that F O B p r i c i n g is the e x c e p t i o n rather than the rule, and that relative competition is the most important factor i n e x p l a i n i n g spatial prices ( G r e e n h u t et a l . 1980). Greenhut et a l . (1981) also show that there are significant differences i n h o w f i r m s set spatial prices between the U S , W e s t G e r m a n y , and Japan, and that price d i s c r i m i n a t i o n is m o r e prevalent i n the latter t w o countries. T h e y also show that i n Japan and W e s t G e r m a n y delivered prices sometimes significantly decrease w i t h distance, although this pattern is never observed i n the U S , and attribute the fact that the U S has antitrust l a w s that f o r b i d f i r m s to charge less to m o r e distant c u s t o m e r s .  84  Summary T h e s e sets o f m o d e l s and studies show that spatial p r i c e d i s c r i m i n a t i o n appears to be p e r v a s i v e . H o w e v e r , a weakness o f Greenhut et a l (1980) and Greenhut et al (1981) is that their w o r k relies o n questionnaires to ask firms to rank the relative competitiveness o f their markets. T h e y also use f i r m s i n different industries w i t h o u t adjusting f o r industry differences, m a k i n g it difficult to quantify the amount o f c o m p e t i t i o n and relate a specific market structure to a particular type o f spatial p r i c i n g .  T h i s a m b i g u i t y also appeared i n the m o d e l s studied throughout this chapter, where it was s h o w n that n o definitive c o n c l u s i o n s c o u l d be d r a w n f r o m the presence o f d i s c r i m i n a t o r y p r i c i n g . T h i s then leaves the basic question unanswered: T o w h a t extent does price  8 4  T h e Robinson-Patman Statute under the C l a y t o n A c t i n the U S restricts firms from setting different prices to the extent such discounts do not reflect differences i n production costs. T h e C o m p e t i t i o n  82  d i s c r i m i n a t i o n represent the exercise o f market power, or s i m p l y c o m p e t i t i v e b e h a v i o r g i v e n the market structure? I n order to answer the question, it i s necessary to d e v e l o p a m o d e l that accurately characterizes the market i n question.  A c t i n Canada does not circumscribe spatial pricing so narrowly (see Director o f Investigation and Research 1992).  83  3. Modeling the Interior Wood Chip Market  ... oligopoly theory has long been claimed to involve indeterminate outcomes, so indeterminate that it is often said that for every economist there is another theory of oligopoly. (Greenhut and O h t a 1 9 9 3 : 3 9 9 )  T h i s chapter discusses the general e c o n o m i c s o f p r o d u c t i o n and the special circumstances that a p p l y to residual w o o d c h i p p r o d u c t i o n . It also e x a m i n e s s u p p l y curves for w o o d chips i n B C to the extent they have been identified, and h o w transportation costs m a y affect p r i c i n g for p u l p f i b r e . F i n a l l y , a specific m o d e l i s developed for the w o o d c h i p market that incorporates the salient features o f w o o d c h i p p r o d u c t i o n and market structure i n the Interior, as w e l l as f i r m interaction.  Supply  of Single  and Joint  Products  T h e t e c h n o l o g y g o v e r n i n g the p r o d u c t i o n o f goods m a y take one o f t w o f o r m s . G o o d s m a y either be p r o d u c e d s i n g l y or as j o i n t products, w h e n t w o or m o r e goods are p r o d u c e d simultaneously. A n e x a m p l e o f single product supply w o u l d be where a l l the w o o d i n a stand is harvested as p u l p w o o d , m a k i n g i t straightforward to identify both the m a r g i n a l and average costs o f p r o d u c t i o n . W h e n p u l p w o o d i s p r o d u c e d j o i n t l y a l o n g w i t h saw l o g s , neither the average costs nor m a r g i n a l costs c a n be identified since i t is i m p o s s i b l e to attribute a l l costs to a specific product.  T h e r e are t w o types o f j o i n t p r o d u c t i o n based o n the p r o d u c t i o n process: t e c h n i c a l l y f i x e d proportions or t e c h n i c a l l y variable proportions. I n the case o f f i x e d proportions, the relative proportions o f p u l p w o o d and s a w l o g s are exogenously f i x e d . N o matter at what l e v e l or relative p r o p o r t i o n the inputs are a p p l i e d , every stand harvested w i l l y i e l d , for e x a m p l e , 2 0 % p u l p l o g s and 8 0 % saw logs. N e i t h e r the l e v e l o f harvesting intensity, the u t i l i z a t i o n o f the tree, nor the design o f the s a w m i l l , c a n change that ratio.  84  In the case o f t e c h n i c a l l y variable proportions, the ratio o f the t w o products c a n be v a r i e d . O n e c a n i m a g i n e harvesting f i v e hectares w i t h the o v e r a l l output v a r y i n g b y the effort e m p l o y e d o n that f i v e hectares, but also w i t h the relative proportion o f each output v a r y i n g i n response to the d e m a n d for the t w o products. Substitution between the t w o outputs m a y lead to greater production o f one at the expense o f the other, or m e a n that the effort i s r e d e p l o y e d towards p r o d u c i n g m o r e o f one product. F o r e x a m p l e , i n harvesting a stand o f trees, r e l a t i v e l y h i g h prices for p u l p fibre m i g h t m e a n that w o o d suitable for l o w grade l u m b e r w o u l d be c h i p p e d instead o f sawed w h i l e s m a l l l i m b s and treetops p r e v i o u s l y left b e h i n d as l o g g i n g debris w o u l d n o w be brought i n to be c h i p p e d .  T h e importance o f both o f these cases is that although the m a r g i n a l cost c a n be identified, g i v e n a prespecified l e v e l o f production, the average cost o f either output cannot because o f the nature o f the j o i n t production. A m o r e practical p r o b l e m is that the different types o f supply offer different b i n d i n g constraints; for e x a m p l e , i n the case o f t e c h n i c a l l y f i x e d proportions, i n c r e a s i n g the p r o d u c t i o n o f one product requires i n c r e a s i n g the p r o d u c t i o n o f the other. F o r t e c h n i c a l l y variable proportions, i t m a y be possible to m a k e adjustments i n product m i x w i t h o u t increasing o v e r a l l production. T h a t i s , the relative proportions o f l u m b e r to chips m a y be v a r i e d without c h a n g i n g l o g c o n s u m p t i o n .  Sources  of Heterogeneity  in Wood  Chips  T h e goal o f w o o d c h i p p r o d u c t i o n is to produce a u n i f o r m series o f rectangular pieces o f the same thickness. B e c a u s e o f the nature o f the p r o d u c t i o n process, irregular and oversize pieces w i l l be p r o d u c e d as w e l l . T h e 1970s saw the i n t r o d u c t i o n o f the K a m y r continuous digester (the c o o k i n g vessel i n w h i c h w o o d fibre is b r o k e n d o w n into p u l p ) r e p l a c i n g the batch digesters used before. T h i s i n turn required m o r e consistency i n the w o o d c h i p s , as variations i n the size o f c h i p s affected the y i e l d . P r e v i o u s l y , it was possible to adjust the c o o k i n g conditions for each i n d i v i d u a l batch. R e c e n t l y , m a n y p u l p m i l l s have introduced p r i c i n g systems designed to encourage the p r o d u c t i o n o f certain c h i p sizes and penalize  those that fall outside what are considered acceptable ranges. A s a consequence, w h i l e residual chips appear to have varied w i d e l y i n the early stages o f the development o f the industry, such differences had v a n i s h e d b y the late 1980's.  T h e m a i n differences between w o o d chips n o w l i e i n the species f r o m w h i c h they are derived. A s noted earlier, the predominant l u m b e r m i l l e d i n the Interior is spruce, pine, a n d fir, or S P F , and consequently the b u l k o f c h i p s p r o d u c e d i n the Interior are S P F c h i p s . H o w e v e r , there are significant amounts o f D o u g l a s - f i r , cedar, and h e m l o c k i n certain areas. T h e greatest difference between these tend to be process specific; for e x a m p l e , a T M P m i l l w i l l prefer to use spruce, c o m p l e t e l y a v o i d D o u g l a s - f i r , and keep the pine content b e l o w certain levels, due to some o f the extractives present i n the latter t w o w o o d s w h i c h affect the quality o f the p u l p . C e d a r , because o f its l o w e r density a n d darker c o l o r , requires additional bleaching and takes u p m o r e digester space relative to the denser w h i t e w o o d s and consequently sells at a discount to the w h i t e w o o d s ( G a s t o n et al 1995). H e m l o c k i s a desirable w h i t e w o o d , b e i n g naturally bright, but occurs i n l i m i t e d stands i n the Interior but is c o m m o n o n the Coast. T h e most c o m m o n p r o b l e m associated w i t h h e m l o c k tends to be the fact that it m a y contain h i g h amounts o f decadent w o o d w i t h the associated rot w h i c h needs to be screened out.  Equilibrium  with  Joint  Production  In competitive product and factor markets a l l prices are simultaneously determined such that a s a w m i l l p r o d u c i n g both l u m b e r and w o o d c h i p s earns n o r m a l profits. In e q u i l i b r i u m , profit m a x i m i z a t i o n means that the marginal value o f each product equals the price o f the input (alternatively, the ratio o f the output prices equals the ratio o f the m a r g i n a l costs i n terms o f the input). In terms o f the inputs, it is c o m m o n to assume that most inputs are perfectly elastically s u p p l i e d .  85  H e n c e a l l inputs w o u l d also be earning n o r m a l e c o n o m i c  returns, w i t h any excess returns attributed to any input that is fixed i n nature. In the T h i s simply means that any quantity o f the input can be obtained at a given price.  context o f the forest industry, i t i s standard to assume that any excess returns after the returns to capital are calculated can be attributed to the other f i x e d factor w h i c h is the resource itself. T h i s is c o m m o n l y c a l l e d economic rent and is the payment i n excess o f that necessary to b r i n g that factor into p r o d u c t i o n . I n the s i m p l e case o f harvesting a h o m o g e n o u s stand o f trees, the e c o n o m i c rent w o u l d consist o f the value o f those trees d e r i v e d f r o m the products they c o u l d produce, less the cost o f p r o d u c i n g those products and harvesting the trees ( i n c l u d i n g a n o r m a l return to capital). T h e rent c o u l d be nonexistent i f the value o f those trees j u s t equaled the cost o f harvesting t h e m a n d converting t h e m into f i n a l outputs.  T h e goal o f government p o l i c y is to c o l l e c t this rent through charges f o r the access to p u b l i c t i m b e r or stumpage ( c o m m o n l y defined as the price p a i d for standing timber). In order to calculate the possible rent, then, it i s necessary to k n o w both the v a l u e o f products d e r i v e d f r o m a tree a n d the costs o f p r o d u c i n g those products ( i n c l u d i n g harvesting). A s o u t l i n e d above, those costs cannot be separated; this means that any total measure o f rent cannot be solely attributed to one product i n the presence o f j o i n t p r o d u c t i o n .  T h e issue o f the appropriate level o f rent capture has been o f major importance i n the B C forest industry for m u c h o f the last t w o decades ( S c h w i n d t a n d H e a p s , 1996). B e c a u s e an appraisal system is used to determine charges for C r o w n t i m b e r i n B C , the c o m p l e x interaction between j o i n t production, c o u p l e d w i t h substantially different end markets, w i t h one g o o d an intermediate g o o d a n d the other a final g o o d , m a k e a d m i n i s t e r i n g such a system extremely difficult. A s A n d e r s o n (1980) points out, the potential exercise o f market p o w e r i n timber markets due to the prevalence o f regional m o n o p o l i e s c o m m o n to the forest industry o n l y adds to the difficulty i n ensuring that any stumpage system based o n appraisals w i l l generate the appropriate charges.  I n p u t  Prices  Under  Different  Supply  C o n d i t i o n s  It s h o u l d be noted that because o f the technology, the p r i c e o f a product m a y have no bearing o n the l e v e l o f production at certain prices. F o r e x a m p l e , a firm m a y find that i n p r o d u c i n g s o l i d l u m b e r a certain p o r t i o n o f the l o g w i l l e n d up as waste, either as sawdust or w o o d chips, and that p o r t i o n cannot be m i n i m i z e d b e y o n d a certain amount. T h e  firm  w i l l m a x i m i z e profits by setting the m a r g i n a l revenue product o f its input (assumed to be logs) equal to the p r i c e o f the output, w h i c h w o u l d equal the v a l u e o f the s o l i d w o o d and w o o d c h i p s a n d sawdust that l o g c o u l d produce. I f there were disposal costs associated w i t h any o f the residual by-products, these w o u l d be subtracted f r o m the output price. In this case, then, there i s n o tradeoff between the t w o products, and the firm's profits are m a x i m i z e d where the m a r g i n a l cost o f production equals the price o f a l l the outputs. B e c a u s e residual w o o d chips are a consequence o f l u m b e r p r o d u c t i o n , p o s i t i v e quantities w i l l be produced even i f the market price for w o o d chips is zero or negative (that i s , there are disposal costs) so l o n g as the net output price exceeds the costs o f p r o d u c t i o n . N o t i c e that an increase i n the l u m b e r price m a y cause o v e r a l l production o f l u m b e r and hence w o o d chips to increase, e v e n i f there i s n o change i n d e m a n d for w o o d c h i p s . A l t e r n a t i v e l y , at l o w enough l u m b e r a n d c h i p prices, a s a w m i l l m a y choose to shut d o w n , causing the p r o d u c t i o n o f both to cease.  In this e x a m p l e , the quantity demanded o f w o o d chips is less than the quantity s u p p l i e d (or m a y even be nonexistent). T h e nature o f the technology i s such that positive quantities o f residual w o o d chips are p r o d u c e d e v e n i n the presence o f market signals (non-positive prices) that w o u l d l e a d to a reduction i n production under other supply conditions. H o w e v e r , i f the d e m a n d for w o o d chips increases to the degree that the s a w m i l l perceives i t is w o r t h processing additional timber g i v e n current costs, then e v e n i n the case o f t e c h n i c a l l y fixed proportions, the output o f residual w o o d chips w i l l increase (as h o w e v e r w o u l d the p r o d u c t i o n o f l u m b e r ) .  In the case o f t e c h n i c a l l y variable proportions, relative output prices w i l l determine relative output proportions. I n the case o f a s m o o t h l y continuous t e c h n o l o g y , non-positive w o o d c h i p prices (and p o s i t i v e l u m b e r prices) w o u l d m e a n no residual w o o d chips w o u l d be produced. P o s i t i v e d e m a n d i n this case w o u l d lead to positive prices for and p r o d u c t i o n o f w o o d c h i p s . I n this case, the m a r g i n a l cost o f w o o d chips c o u l d be the cost o f the s o l i d w o o d forgone at the expense o f w o o d c h i p p r o d u c t i o n .  F o r w o o d chips there are several possibilities i n terms o f supply, each w i t h i m p l i c a t i o n s for h o w prices are determined. T h e first p o s s i b i l i t y i s that w o o d chips are the sole product, and the price w i l l equal the m a r g i n a l cost o f p r o d u c t i o n . T h e second p o s s i b i l i t y is that they are a j o i n t product, i n w h i c h case the technology m a y be such that w o o d chips are produced i n excess o f the perceived d e m a n d and prices m a y be zero o r e v e n negative. A t this point i t is instructive to examine the actual mechanics o f w o o d c h i p production i n the Interior o f BC.  W o o d c h i p p r o d u c t i o n i n the Interior consists o f t w o types o f s u p p l y , r o u n d w o o d c h i p s and residual c h i p s . R o u n d w o o d (or p u l p l o g ) c h i p p r o d u c t i o n c a n be thought o f as the single product type o f s u p p l y and consequently a l l the costs associated w i t h r o u n d w o o d chips c a n be easily i d e n t i f i e d .  86  R e s i d u a l c h i p s are j o i n t l y produced a l o n g w i t h l u m b e r ,  and it is i m p o s s i b l e to c l e a r l y identify the costs o f p r o d u c t i o n o f w o o d c h i p s b y themselves. W h i l e some costs such as c o n v e y i n g systems, storage b i n s , or c h i p h a n d l i n g c a n be directly attributed to the p r o d u c t i o n o f c h i p s , o v e r a l l costs o f p r o d u c t i o n cannot. r Furthermore, the j o i n t production i s o f the t e c h n i c a l l y variable type over certain ranges o f l u m b e r and c h i p values, since l o w grade l u m b e r c a n potentially be c h i p p e d depending o n the relative prices ( N e l s o n et a l 1994).  T h i s distinction might not be so clear-cut i f both pulp logs and sawlogs are simultaneously harvested. In this case, both are joint products from harvesting, and the issues i n v o l v e d i n allocating harvesting costs make it once again impossible to clearly identify the average costs. A l s o , some lumber may be recovered from pulp logs.  L u m b e r has consistently been m o r e valuable than w o o d chips i n the past, a n d s a w m i l l e r s have tended to m a x i m i z e l u m b e r production. A s a consequence, the p r o d u c t i o n o f chips has been m i n i m i z e d and w o o d c h i p p r o d u c t i o n w i t h i n the r e g i o n appears to have been c l o s e l y related to i f not proportional to l u m b e r production. Table 8 shows estimates o f the c h i p r e c o v e r y factor for different regions w i t h i n the Interior for the past ten years, where the recovery factor i s expressed as the amount o f B D U s p r o d u c e d p e r c u b i c metre o f l o g input.  Table 8. Estimated chip recovery factors in the B C Interior 1987-1995 (BDU s per cubic metre of log input) Region Cariboo Kamloops Nelson Prince George Prince Rupert Coast *  1986 .15 .12 .14 .14 .18  1987 .16 .13 .14 .14 .16  1990 .15 .16 .14 .14 .18  1993 .16 .14 .13 .14 .15  1995 .16 .14 .15 .14 .13  1986-87 are lumber mills only; 1990 includes chip mills; 1993 is lumber mills only; Prince Rupert Interior reported separately for 1986-87, combined subsequently Source: Major Primary Timber Processors, unpublished data, MOF  M o r e recently, increases i n the price o f c h i p s relative to poorer grades o f l u m b e r has meant that at times some s a w m i l l s have c h i p p e d what w o u l d otherwise be termed utility grade l u m b e r . T h i s can either take the f o r m o f c h i p p i n g a s m a l l poor quality l o g that w o u l d have o n l y y i e l d e d utility l u m b e r o r c h i p p i n g the utility l u m b e r after i t has been sawn (the latter w o u l d take place i f the s a w m i l l d i d not have a w h o l e l o g chipper). T h e trend appears to be a continued emphasis o n l u m b e r production w i t h some s m a l l scope for m i n o r increases i n c h i p p r o d u c t i o n through changes i n their o p t i m i z a t i o n w h e n prices warrant it. T h i s suggests that the appropriate supply curve for w o o d c h i p s i n the Interior i s r e l a t i v e l y inelastic, although there i s the p o s s i b i l i t y that a reservation price for chips (a m i n i m u m price s a w m i l l s must receive) m a y set a price f l o o r . T h i s reservation price w o u l d be negatively  related to the price o f l u m b e r as discussed i n the preceding section, and w o u l d create an L - s h a p e d s u p p l y c u r v e .  8 7  Figure 10 illustrates such a s u p p l y curve, where the h o r i z o n t a l p o r t i o n i s established b y the reservation price, P w c l . I f the s a w m i l l receives a price equal or greater than this price it w i l l produce the fixed quantity Q l . A higher p r i c e for l u m b e r l o w e r s the horizontal part o f the L - s h a p e d supply curve to P w c 2 but has a m o r e ambiguous effect o n the vertical p o r t i o n o f the supply c u r v e . T h e higher p r i c e m i g h t shift c h i p p r o d u c t i o n i n w a r d through m i n o r changes i n o p t i m i z i n g behaviour, but higher l u m b e r prices c o u l d also increase l u m b e r production and hence c h i p p r o d u c t i o n i f higher prices increased the amount o f timber that c o u l d be harvested or purchased. I f the a l l o w a b l e cut was a b i n d i n g constraint, however, a drop i n a l l o w a b l e cut f r o m A A C 1 to A A C 2 w o u l d shift the vertical portion o f the supply curve for chips i n w a r d and reduce s u p p l y to Q 2 . C h a n g e s i n t e c h n o l o g y that i m p r o v e d l u m b e r recovery relative to c h i p recovery w o u l d also have the effect o f shifting the v e r t i c a l p o r t i o n o f the supply curve i n w a r d s .  88  Unfortunately, there does not exist the data to support a rigorous e x a m i n a t i o n o f the sensitivity o f c h i p p r o d u c t i o n to changes i n prices, technology, harvesting practices, or l o g sizes. H o w e v e r , it is possible to construct a p r o x y for c h i p r e c o v e r y factors to see whether the assumption o f inelastic behaviour is unrealistic.  Figure 11 shows c h i p s p r o d u c e d ( i n  B D U s ) per thousand b o a r d feet o f l u m b e r p r o d u c e d b y forest r e g i o n for the Interior and B C Coast.  8 9  G i v e n that s a w m i l l s w i l l try to m i n i m i z e sawdust and h o g f u e l p r o d u c t i o n ,  for w h i c h they either receive n o m i n a l revenues or i n c u r positive disposal costs, one c a n assume that a n increase i n chips produced per thousand board feet ( M f b m ) comes at the  8 7  T h e N A P A P model used by the Canadian Forest Service to model the N o r t h A m e r i c a n p u l p and paper industry assumes residual c h i p production i n Western Canada is h i g h l y inelastic and perfectly inelastic i n the Western U S (Catimel, 1996).  8 8  T h i s assumes that the effect o f fixed costs being spread across lower production levels and raising average total costs can be ignored.  8 9  Proxies for c h i p recovery were constructed b y taking monthly chip production b y region and d i v i d i n g it by monthly lumber production by region from Statistics Canada Catalog 35-003.  91  Figure 10. Supply Curve for Residual Chips with Reservation Price Based on the Price of Lumber  P P11  Pwd PI2>PI1 Pwc2  Q  y  f  Q2  AAC2 <  Q1  AAC1  Figure 12. Discriminatiory and Non-discriminatory Pricing for Wood Chips from Sawmills with Inelastic Supplies and Transportation Costs  Sawmill Supply Price Sawmill A  E Sawmill E  expense o f l u m b e r p r o d u c e d . T h e r e f o r e , the a m o u n t o f B D U s per M f b m then serves as a p r o x y for the c h i p r e c o v e r y factor for s a w m i l l s , and s h o u l d s h o w h o w the price o f l u m b e r and the price o f c h i p s m a y influence c h i p production.  Figure 1 1 . Chip R e c o v e r y by Region 1 9 9 3 1 995 0.900 0.800 0.700 0.600 E e 0.500 mm  a  0.400  a 0.300 0.200 0.100 T — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — r — i — i — I — i — i — i — i — i — i — i — i — i 0.000 Jan-93 Jun-93 Nov-93 Apr-94 Sep-94 Feb-95 Jul-95 Dec-95  • Southern  Table 9  -ffl— Northern  Central  -A—  -X—Coast  shows the correlation between the above measure o f c h i p r e c o v e r y and product  prices for the three different forest regions i n the Interior.  Table 9. Correlation Between Product Prices and Chip Recovery, 1993-95 Southern  Northern  Central  Std&  (BDU/Mfbm)  (BDU/Mfbm)  (BDU/Mfbm)  Btr  Utility ($Mfbm)  Economy Chip ($Mfbm)  ($/BDU)  ($Mfbm)  1  Southern(BDU/Mfbm) Northern(BDU/Mfbm)  .40  Central (BDU/Mfbm)  .39  .60  Std & Btr($Mfbm)  -.25  -.45  -.72  Utility($Mfbm)  -.15  -.44  -.72  .91  Economy($Mfbm)  -.22  -.05  • -.54  .47  .45  .19  .21  .74  -.56  -.71  Chip ($/BDU)  1 1 1 1 1 -.74  1  Source: lumber prices from Madison's 1993-95, Chip price reported for Northern Interior from WoodFibre Northwest 1993-95; Chip and lumber production from Statistics Canada 35-003  T h e results suggest that l u m b e r prices are negatively correlated w i t h c h i p recovery; as l u m b e r prices increase, c h i p recovery declines as s a w m i l l s increase l u m b e r recovery. T h e correlation between c h i p recoveries and their o w n p r i c e is quite l o w for the northern a n d southern regions, as w o u l d be expected w i t h a n inelastic s u p p l y curve. S u r p r i s i n g l y enough, h o w e v e r , the central r e g i o n (corresponding to the C a r i b o o Forest R e g i o n ) , s h o w e d a m u c h higher correlation between the c h i p recovery proxies and l u m b e r and c h i p prices. T h i s m a y reflect the fact that the central r e g i o n is the smallest r e g i o n i n terms o f c h i p p r o d u c t i o n and the results m a y reflect m o r e u n i f o r m i t y o f f i r m s w i t h i n this area or the development o f r o u n d w o o d c h i p p i n g capacities b y s a w m i l l s w i t h i n the r e g i o n .  T h e s e results, h o w e v e r , are o n l y suggestive. M o r e rigorous a n a l y s i s w o u l d require data on l o g inputs o n a m o n t h l y basis as w e l l as a m o r e detailed description o f the s a w m i l l s w i t h i n each r e g i o n (as c h i p recovery varies b y the type o f product p r o d u c e d , the size and species o f logs s a w n , a n d s a w m i l l configuration). I n a d d i t i o n , the p e r i o d above covers significant changes i n p r i c e levels for w o o d chips that m a y affect the apparent results; as w e l l , some o f the reported c h i p p r o d u c t i o n m a y i n c l u d e r o u n d w o o d c h i p s . T h i s i n turn w o u l d raise the apparent c h i p recovery factor and w o u l d also affect the apparent responsiveness to changes i n the c h i p p r i c e .  Integrating  Demand  and  Supply  In order to integrate d e m a n d and supply, i t is necessary to incorporate transportation costs. S a w m i l l s tend to be located near their harvesting areas to m i n i m i z e l o g - h a u l i n g costs and, as a consequence, are dispersed throughout the I n t e r i o r .  90  P u l p c o m p a n i e s require both  access to their raw material needs as w e l l as the need to m i n i m i z e their o w n transportation  9 0  A firm processing raw material has to take transportation costs into account for both the unit o f input and output. Because the processing of raw material may result i n discarding a portion o f the material, the firm w i l l w e i g h the benefits o f processing as close to the site as possible to m i n i m i z e the transport o f what w i l l be waste material after processing. There is an added cost o f being further away from its final markets, however.  94  costs to their final market. A s noted earlier, their large r a w material needs tend to l i m i t the potential number o f p u l p m i l l s i n an area; however, the transportation network i n the Interior l i m i t s the number o f possible locations a n d has a n opposite effect.  Because  w o o d chips are b u l k y , transportation costs are r e l a t i v e l y h i g h per unit. Therefore, transportation costs c a n be significant w h e n evaluating alternative markets for w o o d chips.  Current transportation costs today range f r o m a p p r o x i m a t e l y 10-20 cents per B D U per k i l o m e t e r for trucks, and 7 cents per k i l o m e t e r b y r a i l w h e n f i x e d l o a d i n g and u n l o a d i n g charges are i g n o r e d . B a s e d o n i n t e r v i e w s w i t h industry participants, average transportation costs i n the Interior range f r o m $ 1 2 to $ 2 5 per B D U , depending o n distances a n d h a u l roads ( K u a n 1997, E d g s o n 1995, Pinette 1995). T h e s e costs appear to have remained unchanged for the past several y e a r s .  A Model  of Price  Discrimination  91  in a Wood  Chip  Market  T h e m o d e l developed b y G e l d h a r t and C a r r o l l (1980) to examine the A l b e r t a w o o d c h i p market c a n be used to illustrate the relationship between price levels, p r i c e patterns, a n d competitive markets. F i g u r e 12 illustrates w h a t a supply curve w o u l d l o o k l i k e w h e n a p u l p m i l l receives w o o d chips f r o m s a w m i l l s that l i e increasingly distant and the quantity purchased varies directly w i t h distance. T h e p u l p m i l l , located at O , purchases chips that are supplied inelastically b y a number o f s a w m i l l s that l i e a l o n g the l i n e O E . E a c h s a w m i l l is identical and has a reservation price or supply p r i c e , O A , that must be met before it w i l l sell its chips. I n a d d i t i o n , there are p o s i t i v e transportation costs, t, that increase directly w i t h distance. U n d e r these conditions the supply c u r v e i s A S , and the c o m p e t i t i v e price at the p u l p m i l l gate is established by the intersection o f the d e m a n d curve ( D ) w i t h the supply  \  curve ( A S ) . S a w m i l l E is the m a r g i n a l supplier a n d receives E D , exactly equal its reservation p r i c e , w h i l e the total quantity purchased i s O E . In this case, the p u l p m i l l pays 91  A contract between a trucking company and sawmill i n the Interior dated 1987 works out to a rate of . 15 per B D U per kilometer, based o n a fuel cost o f 3 9 cents per litre (now 50 cents for diesel) ( D C T Chambers 1987).  95  the same d e l i v e r e d cost for a l l c h i p s , O B , regardless o f where they originate. E a c h s a w m i l l then receives a different net p r i c e , B D , based o n the transportation costs f r o m their l o c a t i o n to the p u l p m i l l , w i t h the net price f a l l i n g for m o r e distant s a w m i l l s due to their higher transportation costs ( s a w m i l l A receives the f u l l p r i c e O B ) . I n this case, there is no price d i s c r i m i n a t i o n , as the p u l p m i l l pays the same price delivered to the p u l p m i l l gate for a l l chips regardless o f where they originate.  U n d e r conditions o f no price d i s c r i m i n a t i o n , then, the most l i k e l y explanation for the b e l i e f that prices are too l o w or u n c o m p e t i t i v e l y l o w is that not a l l the costs associated w i t h c h i p p r o d u c t i o n have been identified. A s s u m i n g the supply p r i c e o f s a w m i l l s does not take into account the alternative o f h a v i n g to i n c u r disposal costs, it is easy to see w h y there m a y be a perception that prices are "too l o w " . E v e n i f the p u l p m i l l i s p a y i n g the same p r i c e delivered at the p u l p m i l l gate to a l l s a w m i l l s , satisfying the competitiveness c o n d i t i o n , there m a y be s a w m i l l s for w h i c h the net price does not c o v e r their direct costs. A s a n example, i m a g i n e the p u l p m i l l is p a y i n g $ 4 0 / B D U delivered, w h i l e the s a w m i l l estimates that i t requires at least $ 4 5 / B D U , so the s a w m i l l perceives i t is l o s i n g $ 5 / B D U . H o w e v e r , the costs o f d i s p o s i n g o f unprocessed residue is $ 1 0 / B D U , so the s a w m i l l is a c t u a l l y m a k i n g a surplus o f $ 5 / B D U b y p r o d u c i n g and s e l l i n g the chips to the p u l p m i l l .  9 2  In the above example the purchaser p a i d the same d e l i v e r e d price to the p u l p m i l l gate for a l l chips w h i l e the suppliers t o o k care o f transportation. If, h o w e v e r , the p u l p m i l l take into account the effect it has o n market prices b y constructing a m a r g i n a l expenditure curve (not pictured), it c o u l d restrict its purchases and thereby l o w e r prices, i n c r e a s i n g profits. M a r k e t p o w e r w o u l d i n this case be expressed as a reduction i n the price b e l o w O B , a n d the quantity purchased w o u l d c o r r e s p o n d i n g l y f a l l . H o w e v e r , there w o u l d still be n o price  ' T h e r e were producers w h o , for one reason or another, were not signed up to sell their chips to Interior pulp mills and i f they wanted to dispose o f them it was costing $8 to $10 a bone dry unit about 2 1/2 tons - to put them into landfill or burn them." Globe and Mail, September 22, 1979  96  d i s c r i m i n a t i o n as s a w m i l l s w o u l d still receive different net prices based o n the transportation costs for their l o c a t i o n .  P r i c e d i s c r i m i n a t i o n is practiced w h e n the purchaser pays each supplier the same p r i c e at the s a w m i l l gate, as i n Figure 12. T h e purchaser n o w pays each i n d i v i d u a l supplier O A , w i t h the delivered cost equaling A S , the supply curve. U n d e r such a p r i c i n g arrangement, s a w m i l l s are unable to derive a surplus f r o m their l o c a t i o n , and the f i r m is practicing d i s c r i m i n a t o r y p r i c i n g b y effectively p a y i n g m o r e for distant w o o d chips, even though the value o f the chips are identical once delivered to the p u l p m i l l . T h e buyer captures the surplus b y p a y i n g the s a w m i l l ' s supply p r i c e and a s s u m i n g the transportation costs. N o t e that the most distant s a w m i l l s u p p l y i n g the p u l p m i l l , E , is still located at the intersection o f the d e m a n d and supply curves, and the amount purchased, O E , is unchanged f r o m the competitive solution.  Figure 1 3 . Sawmill and Delivered Prices f o r D i f f e r e n t Sawmills and Pulp mills in t h e I n t e r i o r f o r t h e T h i r d Quarter of 1 989 1 20 110  a m  -%  4*  100 90 80 70 60 50  100  1 50  200  kilometres  — D e l i v e r e d Price -X—Sawmill Price  T h e data s h o w n i n Figure 13 and Figure 14 show the p r i c e for w o o d c h i p s at the s a w m i l l gate and an i m p u t e d delivered price to the p u l p m i l l .  93  9 3  T h e s e figures suggest that a  Transportation costs o f 15 cents per B D U per k m were added to the sawmill prices. Purchasers and sawmills differ between figures and consists of twelve different transactions i n F i g u r e 13 and thirteen different transactions i n F i g u r e 14, consisting o f three different purchasers and seven different sawmills).  97  d i s c r i m i n a t o r y p r i c i n g scheme does exist i n the Interior o f B r i t i s h C o l u m b i a . Regardless o f their distance f r o m the p u l p m i l l , s a w m i l l s tend to receive s i m i l a r prices for their w o o d chips. D o e s this m e a n that purchasers are e x e r c i s i n g their market p o w e r and that the market for chips is not competitive?  Figure 1 4 . Sawmill and Delivered Prices f o r Different Sawmills and Pulp Mills in t h e Interior f o r t h e T h i r d Quarter of 1990  100  200  kilometres  Delivered Price •Sawmill Price  T h e m o d e l s and e m p i r i c a l w o r k i n the preceding chapter s h o w e d that l a c k o f c o m p e t i t i o n m a y o r m a y not l e a d to price d i s c r i m i n a t i o n . T h e ambiguous results reflect differences i n market structure a n d assumptions about f i r m behavior. Therefore, i n order to e x a m i n e to what extent m a r k e t p o w e r m a y be a factor i n e x p l a i n i n g prices observed i n the Interior, it i s necessary to use a m o d e l that accurately captures the characteristics o f the Interior market. T h e previous chapter s h o w e d that there i s n o shortage o f m o d e l s i n game theory. O n e o f the reasons for such a n embarrassment o f riches is that m a n y m o d e l s are developed to investigate specific questions, such as h o w a particular market structure m a y influence outcomes. C o n s e q u e n t l y , the large n u m b e r o f m o d e l s reflects the c o m p l e x i t y o f the e c o n o m i c environment and the m o d e l e r ' s need to s i m p l i f y that c o m p l e x i t y by c h o o s i n g those e c o n o m i c variables that are deemed most important to that particular set o f circumstances.  98  A  Model  of  the  I n t e r i o r  Wood  Chip  Market  T h e s i m p l e m o d e l o f price d i s c r i m i n a t i o n b y G e l d h a r t and C a r r o l l (1980) y i e l d e d a pattern o f u n i f o r m prices across s a w m i l l s regardless o f the distance between the s a w m i l l a n d p u l p m i l l . T h i s pattern appears to reflect the practice o f f o r m u l a p r i c i n g observed i n the Interior market. H o w e v e r , their m o d e l was based o n a single purchaser, and cannot e x p l a i n w h y a particular price l e v e l m a y be chosen, since under c o n d i t i o n s o f j o i n t p r o d u c t i o n the costs o f c h i p p i n g are not w e l l i d e n t i f i e d . T h i s issue becomes even m o r e problematic as the n u m b e r o f buyers increase, since each buyer w o u l d presumably choose its o w n p r i c e l e v e l , and there is n o reason to expect the buyers to choose a c o m m o n price. G i v e n differences i n f i r m l o c a t i o n , the presence o f alternative buyers (whether they be other p u l p m i l l s or the export market), and the a v a i l a b i l i t y o f residual chips ( w h i c h w o u l d v a r y b y region), the c o m m o n a l i t y o f prices seen i n  Figure 13 and Figure 14 i s e v e n m o r e  striking (especially w h e n c o m p a r e d to the prices for p u l p observed i n  Figure 2). F u r t h e r m o r e , the  m o d e l does not e x p l a i n w h y prices increased so r a p i d l y w h e n p u l p m i l l s started b i d d i n g f o r chips.  N o n e o f the other m o d e l s discussed earlier fit the Interior market any better. First, the market has been relatively static i n terms o f market structure, n a m e l y the distribution and size o f purchasers o v e r the study p e r i o d . Therefore, i n order to answer the question o f whether the observed prices in  Figure 13 and Figure 14 reflect the exercise o f market p o w e r or s i m p l y the influence o f  c o m p e t i t i v e forces, it is necessary to use a m o d e l that examines both prices and p r i c i n g patterns.  In the case o f the Interior market, Chapter 1 identified several important facts regarding the Interior w o o d c h i p market. A s noted above, market structure i n terms o f the n u m b e r o f purchasers has been static. M o s t o f the p u l p m i l l s i n the Interior were c o m p l e t e d b y the early 1980's; o f the t w o built since, both rely entirely o n internal sources f o r chips (the F i b r e c o M i l l i n T a y l o r b y F i b r e c o members and the L o u i s i a n a P a c i f i c M i l l i n C h e t w y n d b y the purchase o f aspen p u l p l o g s ) . R e g i o n a l market structure varies i n one o f the t w o w a y s : either t w o different p u l p m i l l s (that i s , p u l p m i l l s o w n e d b y t w o different companies) are f o u n d i n the same t o w n (as i n P r i n c e G e o r g e , M a c k e n z i e , and Quesnel); or there is o n l y one p u l p m i l l w i t h i n a r e g i o n (as i n K a m l o o p s ,  99  Castlegar, a n d S k o o k u m c h u c k ) w i t h alternative purchasers located at considerable distances (see again F i g u r e 3 ) .  Therefore, i t is necessary to l o o k at games that e x a m i n e the interaction between different d e l i v e r e d p r i c i n g systems a n d firm behavior rather than those that rely o n the n u m b e r o f firms. T h e m a i n approach i n m o d e l i n g such games has been to use the H o t e l l i n g m o d e l as a starting point. T w o o f the m o d e l s e x a m i n e d i n Chapter 2 used such a n approach; h o w e v e r , each m o d e l h a d important s h o r t c o m i n g s . E s p i n o s a (1992) restricted the actions a firm c o u l d undertake w h i c h a priori r u l e d out certain outcomes. T h i s s e a n d V i v e s (1988) d i d not e x a m i n e the i m p l i c a t i o n s o f repeated interaction, n o r d i d they e x a m i n e the i m p l i c a t i o n s o f u n i f o r m d e l i v e r e d p r i c i n g systems. I n addition, both o f these m o d e l s were c o n c e r n e d w i t h market p o w e r o n the d e m a n d side a n d neither paper attempted any e m p i r i c a l tests o f the m o d e l s .  T h i s meant that i t was necessary to d e v e l o p a m o d e l that captured the characteristics o f the Interior market w h i l e p r o v i d i n g testable hypotheses. A m o d e l adapting T h i s s e a n d V i v e s (1988) a l o n g w i t h E s p i n o s a (1992) w a s used o n a data set that w o u l d p e r m i t the e x a m i n a t i o n o f whether changes i n firm behaviour c o u l d e x p l a i n the pattern o f prices observed i n the Interior w o o d c h i p market.  T h e m o d e l is constructed i n t w o parts. T h e first part e x a m i n e s the non-cooperative o r N a s h e q u i l i b r i u m f o r duopsonies under t w o different market structures; one where the firms are located together, a n d the other where they are spatially separated. T h e m o d e l then shows that different p r i c i n g patterns emerge as the unique N a s h e q u i l i b r i u m based o n the particular market structure.  T h e second part then examines the effect o f repeated interaction. I n t r y i n g to m o d e l tacit c o l l u s i o n , the favored approach has been to use infinitely repeated o l i g o p o l y games, o r supergames. T h e s e supergames focus o n the characteristics o f the e n v i r o n m e n t that firms find themselves i n to see what factors m a y support outcomes that raise payoffs above the l o w e s t l e v e l o f non-cooperative (or competitive) behavior. T h e difficulty w i t h such games is that they generate a n u m b e r o f possible e q u i l i b r i a , often sustained b y punishments that are never observed. T h e punishment c o m m o n l y 100  takes the f o r m o f a set o f prices or actions b y a f i r m designed to i m p o s e sub-optimal payoffs o n the other firm(s) that deviate(s)). T h e threat o f s u c h punishment is u s u a l l y sufficient i n such games to ensure that firms c o l l e c t i v e l y adhere to a more (collectively) profitable outcome and therefore firms w i l l never deviate i n e q u i l i b r i u m and hence these sub-optimal outcomes are never observed. It i s customary i n this type o f m o d e l i n g to choose the most severe punishment possible to arrive at the e q u i l i b r i u m (for e x a m p l e , a firm m a y threaten to set prices such that n o firm w i l l earn a profit i n perpetuity i f any other firm d e v i a t e s ) .  94  T h i s m o d e l utilizes the non-cooperative outcome f r o m the one-shot game (that is, without repeated interaction) as the punishment i n m o d e l i n g the supergame. It turns out that the basic m o d e l offers some powerful insights into h o w market p o w e r and firm l o c a t i o n c a n interact to produce both changes i n price levels and changes i n p r i c i n g systems s i m i l a r to those seen i n the B C Interior w o o d c h i p market. T h e m o d e l s h o w s that the pattern o f c o m m o n prices across suppliers ( s a w m i l l s ) does not emerge under the assumption o f competitive behaviour, regardless o f market structure, and that this pattern c a n o n l y be sustained under certain conditions.  B e c a u s e most m o d e l s are c o n f i g u r e d w i t h firms selling to spatially dispersed consumers, i t s h o u l d be emphasized that the m o d e l b e l o w has been adapted to have firms p u r c h a s i n g f r o m spatially dispersed suppliers.  F i r m s are located under t w o different configurations. I n the first, they l i e at either end o f a l i n e segment o f unit length (separate locations); i n the second, they both l i e at the same e n d o f the l i n e segment (coincident locations). Suppliers are distributed w i t h unit density o v e r the i n t e r v a l X=[0,1], w i t h firm 1 l o c a t e d at 0 and firm 2 at 1 w h e n they are separately located, and both at 0 under c o i n c i d e n t locations. F i r m s purchase inputs f r o m their suppliers a n d use a L e o n t i e f , o r  fixed  T h e difficulty with this approach is two-fold: first, different assumptions about punishment w i l l generate different e q u i l i b r i a and one never has an opportunity to observe any "punishment"; and second, the choice o f punishment (as i n the example) may not be plausible and appear somewhat arbitrary.  9 4  101  factor t e c h n o l o g y , to process the purchased i n p u t w i t h other factors to produce outputs s o l d into c o m p e t i t i v e markets. Therefore, firms w i l l have equal and constant m a r g i n a l revenue products, R j , less the cost o f other factors o f p r o d u c t i o n .  95  Initially let F i r m 1 be the l o w cost  producer a n d F i r m 2 the h i g h cost producer s u c h that R , = R and R j = R - c w i t h c>0, w h i l e suppliers p r o v i d e a homogeneous input inelastically.  N o t e that these assumptions actually fit the Interior market quite w e l l . T h e n u m b e r o f buyers i s few, w i t h o n l y t w o buyers i n any one l o c a t i o n (such as P r i n c e G e o r g e o r Q u e s n e l ) , a n d i n m a n y cases s a w m i l l s find themselves l y i n g between t w o buyers w h i l e export restrictions l i m i t the effectiveness o f the export market. I n a d d i t i o n , w o o d c h i p s are h o m o g e n e o u s , g i v e n the species. D u e to their b u l k y nature, and a l i m i t e d transportation network, transportation costs tend to be h i g h relative to the v a l u e o f the product. C h i p p r o d u c t i o n i s fairly continuous. Often, because o f l i m i t e d storage space, s a w m i l l s cannot produce l u m b e r f o r m o r e than a few w e e k s i f they cannot get r i d o f their c h i p s . W i t h the p h a s i n g out o f beehive burners, s a w m i l l s face i n c r e a s i n g costs i f they have to dispose o f their c h i p s , m a i n l y through l a n d f i l l i n g , hence creating a n inelastic supply o f chips. F i n a l l y , m a r g i n a l costs tend to be constant as the proportions o f c h e m i c a l s , energy, and labor used i n the manufacture o f p u l p are fixed i n the short run, l e a d i n g to a constant m a r g i n a l revenue product for the fibre input based u p o n the s e l l i n g p r i c e o f p u l p ( A r m s t r o n g , 1975).  Initially, this is a two-stage game, w h i c h means that firms m a y first choose to c o m m i t to a particular p r i c i n g p o l i c y and then choose their prices. I n this case, the t w o p r i c i n g p o l i c i e s available to the purchasers are either uniform pricing ( U P ) o r discriminatory pricing ( D P ) . U n d e r u n i f o r m p r i c i n g , the p u l p m i l l chooses to set a u n i f o r m price f o r residual c h i p s d e l i v e r e d to the p u l p m i l l gate, regardless o f the distance traveled. T h i s means that the net price to the s a w m i l l then falls as the distance between it and the p u l p m i l l purchasing the c h i p s increases. T h i s type o f p r i c i n g system is o f interest since this i s what w o u l d be observed under the rationale o f the " L a w o f O n e P r i c e " ; that is, the p u l p m i l l pays the same f o r a l l c h i p s , regardless o f where they originate.  9S  R w i l l be dependent on the output price. If, for example, there were no other costs, and 2 units were need to make one unit o f output sold for p, then R=p/2.  102  U n d e r d i s c r i m i n a t o r y p r i c i n g , firms retain their freedom to choose to compete o v e r the entire range o f the market i n prices, resulting (as I w i l l show) i n a N a s h E q u i l i b r i u m i n prices at the supplier. D i s c r i m i n a t i o n refers to the fact that net prices to the supplier, or alternatively, the delivered p r i c e to the m i l l - g a t e for t w o goods c o m i n g f r o m t w o different locations m a y vary b y other than the actual transportation costs between those t w o points. N o t i c e that this type o f p r i c i n g does not restrict the f i r m to any particular type o f d e l i v e r e d p r i c i n g system, o f w h i c h u n i f o r m p r i c i n g is a subset.  In addition, f i r m s anticipate the e q u i l i b r i u m prices under the different p r i c i n g systems w h e n c h o o s i n g a m o n g p r i c i n g schemes. B e c a u s e there m a y not exist a pure N a s h e q u i l i b r i u m at the second stage w h e n one f i r m chooses u n i f o r m p r i c i n g , i t is assumed that the f i r m that chooses to price u n i f o r m l y becomes the price leader w h i l e the other f i r m w i l l react o p t i m a l l y to the first f i r m ' s prices. U n d e r these assumptions, there are f o u r possible outcomes. F i g u r e 1 5 shows the game tree for these outcomes, where both f i r m s either b o t h choose to p r i c e u n i f o r m l y , or b o t h choose to price discriminate, or one o f the t w o f i r m s becomes the price leader b y c h o o s i n g to p r i c e uniformly.  T h e latter t w o cases l e a d to the p r i c i n g system c a l l e d basing-point p r i c i n g ( B P P ) . U n d e r these circumstances, this type o f p r i c i n g arises under c o m p e t i t i v e b e h a v i o u r . S u p p o s e f i r m s ( s a w m i l l s ) are situated i n different locations, and F i r m 1 chooses to p r i c e u n i f o r m l y . F i r m 2 c a n then choose to set its price fractionally higher, or an e p s i l o n above F i r m I ' s net price to the supplier wherever the net price plus transportation costs to F i r m 2 are less than its m a r g i n a l revenue product. F i g u r e 1 6 shows that F i r m 1 w i l l set a price o f P at the p u l p m i l l gate; F i r m 2 then prices d i s c r i m i n a t o r i l y s u c h that it pays the same net p r i c e as a supplier w o u l d receive f r o m F i r m 1 ( P P ' ) . F i r m 2 w o u l d then purchase out to where the d e l i v e r e d cost (the net p r i c e plus the transportation cost for that supplier) w i l l just equal the m a r g i n a l revenue product for F i r m 2 (R2), y i e l d i n g the market  103  Figure 15. Game Tree for Firms that Either Commit to Price Uniformly (UP) or Retain Their Freedom to Price Discriminate (DP) UP  N a s h in prices  Firm 2  Firm 1  Firm 1 price leader  Firm 2 price leader  N a s h in price s c h e d u l e s D r a w n from T h i s s e a n d V i v e s (1989)  104  \  Figure 16. Basing Point Pricing with Firm 1 the Price Leader  105  boundary between the t w o  firms(BB').  It c a n be seen that F i r m 2 w i l l enjoy larger profits  than F i r m 1 (this is s h o w n i n the next section); consequently, n o f i r m w o u l d choose to be a p r i c e leader g i v e n the assumption o f non-cooperative b e h a v i o u r .  T h e next section l o o k s at the sub-game e q u i l i b r i a o f the game under each o f the t w o scenarios.  Coincident Location W i t h coincident l o c a t i o n , B e r t r a n d c o m p e t i t i o n means that the o n l y sub-game perfect e q u i l i b r i u m i s where both firms choose u n i f o r m p r i c i n g . I f c>0, then F i r m 2 w i l l be shut out o f the m a r k e t a n d F i r m 1 w i l l price an e p s i l o n above R - c a n d secure the entire market. I f c=0, both firms price at R and earn zero profits.  Proof: If either Firm I or Firm 2 choose a price such that p(x)<R-c-tx at any point, then the other firm could purchasefromthe supplier at that point and earn a positive profit. If, however, p(x)>Rc-tx at any point, Firm 2 will earn negative profits by purchasing from that supplier and since they have the option of not purchasing and earning zero profits, will not pay that price. Firm I, given that price, can increase profits by lowering the price it pays; therefore, any prices strictly greater are not stable. Therefore, the only subgame perfect equilibrium is where p(x)=R--c-tx which is equivalent to uniform pricing where p=R-c when bothfirmsare located coincidentally.  Separate Locations U n d e r separate locations, h o w e v e r , both firms (pulp m i l l s ) can r e m a i n i n the market under either p r i c e system, so l o n g as t > R - c . In this case, then, there are f o u r p o s s i b i l i t i e s , o u t l i n e d b e l o w .  C a s e 1. ( U P , U P ) : T h e market boundary between the t w o firm's area i s g i v e n by the l o c a t i o n x o f the supplier indifferent between the t w o net prices offered:  106  w h i c h yields:  = (A ~ Pi +t)/2t  X  G i v e n that suppliers are distributed u n i f o r m l y , profits are then g i v e n b y :  JTj = (R- p )x {  and  jt  =(R-c-p \l-x)  2  2  U s i n g the first order c o n d i t i o n s , this then y i e l d s e q u i l i b r i u m prices  {R-t  -c/3,R-t-2c/3)  respective market areas  I I __£\  (JL \6t  2 2~6t)  +  ,  and respective profits  [ f £ A ( 3 + cr) +  l b  |  r 6  C—+  ' \3 '  /V3-c/)^  1  z  |  6  |  C a s e 2 . ( D P , D P ) : W h e n both f i r m s choose to retain their freedom to price discriminate i n the second stage, then the e q u i l i b r i u m p r i c e schedule i s :  p*(x) = min { R-c-t(l-x), R-tx } w i t h x between [0,1] as B e r t r a n d c o m p e t i t i o n drives prices u p to the lowest net revenue o f the t w o firms at that l o c a t i o n . T h e market boundary then becomes  R-c-t  - +tx = R-tx  c 1 => x = — + — 2t  2  E q u i l i b r i u m profits then become  \ X  =J[R-(R  JI  X  -C -  t(l -  JC)) -  tx\dx  0  for F i r m 1 a n d  i  7t =j[R-(R-tx) 2  -(c + Kl-x))}ix  x  for F i r m 2 .  C a s e 3 . ( U P , D P ) : I n this case, F i r m 1, the h i g h revenue producer, i s the price leader a n d chooses set a u n i f o r m m i l l gate price o f p , . F i r m 2 then matches the price wherever i t can a n d the market boundary i s then determined b y the indifferent supplier, or:  p -tx = R -c-t(l - xj x  Profits f o r F i r m 1 are g i v e n b y  108  (R-Pi)x  w h i c h , g i v e n the first order conditions, y i e l d the o p t i m a l p r i c e f o r F i r m 1 a n d market boundary  c+ t  p ,=R D  At 4  X  +  T h e e q u i l i b r i u m price schedule f o r F i r m 2 then becomes  p*2(x) = m i n {/A  -tx,R-c-t(l-x)}  and profits are then  JZ = J*. [R - (p - tx) -c-t(l2  {  x)\ix  C a s e 4 . ( D P , U P ) : I n this case the l o w e r revenue o r m o r e inefficient F i r m 2 i s the price leader a n d prices u n i f o r m l y , w i t h f i r m 1 then m a t c h i n g the price w h e r e v e r possible.  T h e market boundary then becomes  R + t-p^ x= It  and f o l l o w i n g the same arguments as above, the o p t i m a l price a n d market area for F i r m 2 b e c o m e  109  P2  -/?-  . 1 X =—+ 2  (c t) +  c+ t 4r  and profits for F i r m 1 are then  JTj = J [R-tx-(p*2  -?(l-x))j±c  T a b l e 10 then shows the e q u i l i b r i u m payoffs for each f i r m . Several points then emerge. First, d i s c r i m i n a t o r y p r i c i n g emerges as a d o m i n a n t strategy for both f i r m s and, as such, i s the unique subgame-perfect e q u i l i b r i u m . H o w e v e r , the p a y o f f for both i s greater i f each use u n i f o r m p r i c i n g rather than both practicing discriminatory p r i c i n g .  96  T h i s is the classic prisoner's d i l e m m a , and  suggests that d i s c r i m i n a t o r y p r i c i n g emerges as the non-cooperative e q u i l i b r i u m i n a one-shot game (that is, without repeated interaction). W h i l e each f i r m perceives it w o u l d be i n their mutual selfinterest i f both chose u n i f o r m p r i c i n g , each recognize that the other w i l l not adhere to such a system, and that the f i r m that continues to set u n i f o r m prices w i l l be worse off. Therefore, to forestall such an outcome, each f i r m chooses a d i s c r i m i n a t o r y p r i c i n g system, f u l f i l l i n g their expectations about the other's b e h a v i o u r .  Table 10.  F i r m Payoffs Under Different Pricing Strategies  Firm 2 Firm 1 Uniform Pricing Discriminatory Pricing  9 6  Uniform Pricing  {- +t)(3 + ct) (— + t)(3-ct) \3 ) \3 ) 6  '  Discriminatory Pricing  (c + tf St  (c-3tf '  16r  6  (c + 3t) 16t ' 2  {c-tf 8t  (c + tf (c-tf At ' At  T h e payoffs become clearer i f c=0 w i t h no loss o f generality. Profits when both price uniformly equal t/2 versus t / 4 f r o m both practicing price discrimination, w h i l e the greatest profits come from practicing price discrimination w h i l e the other f i r m prices uniformly.  110  Figures 17 and 18 s h o w the e q u i l i b r i u m price patterns for each o f these outcomes. I n  Figure 17, the f i r m s (pulp m i l l s ) are free to choose the p r i c e schedule. U n d e r these circumstances, each f i r m (pulp m i l l ) calculates the m a x i m u m amount the other f i r m (pulp m i l l ) c o u l d afford to pay, and then sets its prices to its o w n suppliers ( s a w m i l l s ) a c c o r d i n g l y . U n d e r this discriminatory p r i c i n g arrangement, the prices p a i d to the supplier ( s a w m i l l ) increase w i t h distance f r o m the purchaser (pulp m i l l ) since the rival purchaser (pulp m i l l ) c a n afford to pay m o r e as the distance between it and the supplier ( s a w m i l l ) decreases. T h e market boundary i s then determined b y the supplier ( s a w m i l l ) whose d e l i v e r e d cost just equals the m a r g i n a l revenue product o f either purchaser (pulp m i l l ) , R ( i n the figure f i r m s have a c o m m o n m a r g i n a l revenue product and  c=0).  In  Figure 18, f i r m s (pulp m i l l s ) are n o w constrained to f o l l o w a practice o f setting prices at the  p u l p m i l l gate. F i r m 1 n o w takes into account the fact that F i r m 2 l o o k s at the d e l i v e r e d cost o f purchasing f r o m F i r m l ' s suppliers, g i v e n that each f i r m is c o m m i t t e d to u s i n g u n i f o r m prices. F i r m 1 finds that b y r e d u c i n g its p r i c e , although it loses its m o r e distant suppliers to F i r m 2 (those f i r m s i n the segment A B ) , , the increase i n profits d e r i v e d f r o m l o w e r i n g the p r i c e f r o m P to P ' to its closest suppliers (segment O A ) m o r e than compensates for the lost supply. E a c h f i r m then takes this effect into account w h e n determining its prices, l e a d i n g to l o w e r e q u i l i b r i u m prices since each f i r m k n o w s the other cannot raise the price to increase its supply area without r a i s i n g the price across a l l o f its o w n suppliers. T h i s constraint is the reason that u n i f o r m p r i c i n g , w h e n practiced by both f i r m s , y i e l d s the greatest profits o f the t w o different systems.  Furthermore, since dpi dR=l, this means that as R, the m a r g i n a l revenue product, increases, l o c a l i z e d B e r t r a n d c o m p e t i t i o n drives u p the purchase price b y an equal amount.  T h i s is w h y R  does not appear i n any o f the payoffs and does not affect any o f the outcomes, as any increase i n end product prices i s c o m p l e t e l y offset b y higher input prices.  Ill  Figure 17. Discriminatory Pricing by Firm 1 and Firm 2  Market b o u n d a r y Firm 2  Firm 1  Distance  Figure 18. Uniform Pricing by Firm 1 and Firm 2  113  Therefore, the m o d e l predicts that i n a non-cooperative game, d i s c r i m i n a t o r y p r i c i n g w i l l emerge for spatially separated purchasers, w h i l e u n i f o r m p r i c i n g w i l l emerge as the e q u i l i b r i u m outcome for firms located c o i n c i d e n t a l l y . P r i c e s c a n be expected to m o v e proportionately w i t h changes i n the end product p r i c e , but p r i c i n g systems w i l l not change.  N o t e that neither price pattern i s that observed i n the B C Interior. F o r c o i n c i d e n t a l l y located p u l p m i l l s , the predicted o u t c o m e i s f o r u n i f o r m p r i c i n g , w h i c h means l o w e r prices for m o r e distant suppliers ( s a w m i l l s ) as the purchasers (pulp m i l l s ) i n c u r h i g h e r transportation costs, w h i l e f o r separately located purchasers, suppliers w i l l f i n d that their prices increase the closer they are to a n alternative purchaser. A l t h o u g h d i s c r i m i n a t o r y p r i c i n g incorporates the possibility o f setting u n i f o r m prices across suppliers (since f i r m s are free to choose any p r i c e system they w i s h ) , t h i s type o f p r i c i n g does not emerge as the s o l u t i o n i n the unconstrained game. Therefore, i t i s necessary to m o d e l u n i f o r m net prices across suppliers to see the potential payoffs f r o m this type o f p r i c i n g system.  Uniform Supplier Pricing P r i c i n g systems i n w h i c h f i r m s charge i d e n t i c a l prices to a l l customers, i n c l u s i v e o f d e l i v e r y costs and regardless o f their l o c a t i o n , are c o m m o n l y c a l l e d Uniform Delivered Pricing ( U D P ) systems (they are also sometimes c a l l e d postage stamp systems). T h e equivalent p r i c i n g system f r o m a purchaser's p o i n t o f v i e w w o u l d be one where they p a y the same p r i c e to a l l suppliers, w i t h transportation costs then added. T o d i s t i n g u i s h i t f r o m the f o u r schemes discussed earlier, i t w i l l be termed U n i f o r m S u p p l i e r p r i c i n g ( U S ) to reflect the fact that prices are set identically across a l l suppliers ( w h i c h i n this case are s a w m i l l s ) .  C a s e 5. ( U S , U S ) : U n d e r u n i f o r m s u p p l i e r p r i c i n g , h o w market areas are d e t e r m i n e d becomes important. B e c a u s e suppliers ( s a w m i l l s ) receive the same price w h i l e the purchaser (pulp m i l l ) pays for the transportation costs, the total d e l i v e r e d cost varies directly w i t h l o c a t i o n so that the chips f r o m the most distant s a w m i l l s u p p l y i n g the p u l p m i l l are the most expensive. I f both  114  purchasers choose a c o m m o n price, then, the suppliers w i l l be indifferent to s e l l i n g to either purchaser and, m a k i n g the c o m m o n assumption i n these m o d e l s that suppliers w i l l sell to the nearest purchaser i n the event o f a tie, the market is then e v e n l y split between both f i r m s .  U n d e r such assumptions, there is a large discontinuity between the payoffs f r o m c o n t i n u e d market sharing and deviating slightly f r o m the c o m m o n price, as the deviating f i r m c a n potentially seize the entire market supply o f the other f i r m (since any supplier w o u l d be w i l l i n g to offer their supply regardless o f their location). D e p e n d i n g o n the current price, the market area for the deviating f i r m m a y effectively double w h i l e the market area for the other f i r m w i l l collapse to zero. H o w e v e r , at higher prices, the d e v i a t i n g f i r m m a y not want to purchase f r o m the most distant f i r m s (those closest to the rival purchaser) as the delivered cost o f goods f r o m those suppliers m a y exceed the m a r g i n a l revenue o f the input.  Therefore, the m o d e l appears i n a s l i g h t l y different fashion f r o m above. T h e assumptions e m p l o y e d i n the previous m o d e l still h o l d (although the assumption c>0 i s dropped for ease o f exposition).  97  First, the f i r m s calculate the payoffs i f they choose a c o m m o n p r i c e (how they  arrive at that c o m m o n price is left aside for the moment):  12 0  and then the payoffs f r o m deviating f r o m that price  Jti = f[R-p  - tx]dx w h e n p s  R-t  o  or  G i v e n symmetric firms, this means that when both firms charge the same price they w i l l share the market equally or x = l / 2 . It turns out that the. solution when c>0 is x=(c+t)/2t, for the h i g h revenue firm, w h i c h equals 1/2 when c=0.  115  R Jt = j[R-p  -tx\  t  wherex =  and p >  R-t  —2 w h i c h equals - j - .  T h e payoffs f r o m not d e v i a t i n g w h e n the other f i r m deviates are then: JEj = 0 w h e n p s  R-t  or 1-1  -2  — jt. = f[R-p  —  tx  - txfix w h i c h equals Rx - px -  o  . ^  T h i s assumes that the f i r m , w h e n deviating, continues u s i n g U S and prices a n e p s i l o n above the other's price (and i s unable to reduce the price over its closest suppliers for fear o f l o s i n g them) when p s R - t  . T h e deviating f i r m practices d i s c r i m i n a t o r y p r i c i n g otherwise, i n w h i c h case  3t  profits become — w h e n f i r m s are sharing equal market areas.  98  8  F i g u r e 1 9 shows the payoffs based o n the market price for market-sharing ( h a v i n g a c o m m o n price) and the payoffs for the deviating f i r m s w h e n one f i r m w i n s market share and the other loses market share and both are f o l l o w i n g a u n i f o r m supplier p r i c i n g system.  T h i s makes the assumption that the deviating f i r m prices such that any supplier w i t h i n their natural market area is indifferent to selling to the other supplier, or p = p - t(l - x). T h i s can be thought o f as a natural arbitrage c o n d i t i o n . i  2  116  Figure 19. Payoffs for Different Pricing Strategies  It c a n be seen that at prices b e l o w R - t / 2 the payoffs f r o m defection dominate the other t w o strategies. B e r t r a n d c o m p e t i t i o n drives prices up to p=R-t/2, w h i c h is a w e a k N a s h e q u i l i b r i u m i n the sense that it is a strategy where the payoffs f r o m a l l three are equal and f i r m s w i l l be indifferent between cooperation and defection. H o w e v e r , the p a y o f f f r o m p r a c t i c i n g p r i c e d i s c r i m i n a t i o n i s greater than f r o m u s i n g U S p r i c i n g w h e n the other firm is p r a c t i c i n g U S p r i c i n g . Therefore, the o n l y N a s h e q u i l i b r i u m w h e n firms both practice U S p r i c i n g y i e l d s payoffs o f t/8, less than the payoffs f r o m retaining the freedom to price discriminate o f t/4 (where c=0), so d i s c r i m i n a t o r y p r i c i n g remains the dominant strategy.  E v e n w h e n firms are constrained to f o l l o w U n i f o r m S u p p l i e r ( U S ) p r i c i n g , the same points still h o l d as i n the unconstrained game (where firms are free to choose the p r i c i n g system). T h e payoffs f r o m market sharing (where both firms choose a c o m m o n price l e v e l ) f o r m once again the classic prisoner's d i l e m m a , and increases i n the m a r g i n a l product translate into a proportionate change i n prices even i f both firms adhere to U S p r i c i n g . A l t h o u g h f i r m s find that they c a n increase profits i f they choose a l o w enough price under a U S p r i c i n g system, firms i n d i v i d u a l l y face the p o s s i b i l i t y o f greater profits f r o m increasing the price fractionally g i v e n the dramatic changes i n market area. In the N a s h e q u i l i b r i u m , each firm w i l l choose the price that ensures their market area, a n d that the price l e v e l w i l l fluctuate directly w i t h changes i n the e n d product value. H o w e v e r , the N a s h  117  e q u i l i b r i u m under j o i n t U S p r i c i n g has l o w e r profits and is d o m i n a t e d b y the e q u i l i b r i u m where f i r m s are free to choose w h i c h e v e r prices they want. Therefore, U S p r i c i n g does not emerge as the outcome o f the unconstrained non-cooperative game. N o t e that for f i r m s located c o i n c i d e n t a l l y , Bertrand c o m p e t i t i o n continues to d r i v e prices up s u c h that u n i f o r m m i l l p r i c i n g is the d o m i n a n t outcome (unless f i r m s are constrained to f o l l o w u n i f o r m s a w m i l l p r i c i n g ) .  T h e m o d e l s o f non-cooperative behaviour o u t l i n e d above show that the pattern o f prices observed i n the Interior o f supplier prices invariant w i t h respect to distance cannot be expected to emerge as the natural outcome o f either type o f market structure g i v e n n o constraints o n h o w f i r m s c a n set prices. T h e m o d e l s predict that w h e n firms are located coincidentally that u n i f o r m m i l l p r i c i n g remains the unique N a s h e q u i l i b r i u m w i t h prices p a i d to supplies falling w i t h distance. I n those markets where purchasers are spatially separated, the m o d e l shows that prices p a i d to s a w m i l l s s h o u l d increase w i t h distance.  In order to understand h o w such systems m a y d e v e l o p , then, it is necessary to e x a m i n e what happens w h e n f i r m s interact o n a n o n g o i n g basis, g i v e n that the m o d e l s above are one-shot games.  99  Repeated Interaction W h a t happens w h e n firms take into account the l i k e l i h o o d that their present actions w i l l have an effect o n future prices? F i r m s n o w take into consideration not o n l y h o w their current price o r action m a y affect current profits, but also the effect o n future profits since their c h o i c e m a y cause the other f i r m to alter its behavior. It turns out that the p o s s i b i l i t y o f future profits tempers competitive behavior, a n d that m o r e profitable strategies m a y emerge f o r both f i r m s than i n a oneshot game.  E s p i n o s a (1992) incorporates the effects o f this interaction t h r o u g h h a v i n g f i r m s engage i n a n infinitely repeated game or supergame. T w o f i r m s face spatially distributed customers w i t h unit  118  inelastic demands and simultaneously choose p r i c i n g strategies and prices at the b e g i n n i n g o f each p e r i o d . T h e f i r m s then compare the payoffs f r o m c o n t i n u i n g to f o l l o w the current p r i c i n g system against d e v i a t i n g f r o m that pattern. I f a f i r m deviates, it enjoys the profits for one p e r i o d , after w h i c h both f i r m s revert to what is termed a punishment path, or a set o f prices designed b y the other f i r m to reduce the profits for the deviating f i r m to the lowest possible l e v e l :  1  l-d  c  „ d  d  p  l-d  In E s p i n o s a ' s (1992) m o d e l , f i r m s have the o p t i o n o f c h o o s i n g one o f t w o p r i c i n g systems: U n i f o r m D e l i v e r e d P r i c e system ( U D P ) , (where customers pay the same d e l i v e r e d price at their location); and F O B p r i c i n g (where customers pay a c o m m o n factory gate p r i c e plus the transportation costs to their location).  1 0 0  I n m a x i m i z i n g their profits, the firms are t a k i n g into  account the benefits o f continued cooperation versus the one p e r i o d gain f r o m defection. T h e result o f such assumptions i s that the p r i c i n g scheme and price l e v e l adopted b y both purchasers w i l l be the same i n e q u i l i b r i u m w i t h the c h o i c e o f prices and p r i c i n g systems dependent o n the exogenous parameters w i t h i n the m o d e l . T h e m o d e l has three such parameters: 6, the discount factor or rate; t, transportation costs; and R , the reservation value o f the c u s t o m e r s .  101  I n this m o d e l , the  discount rate measures the relative payoffs f r o m continued cooperation and possible defection and is bordered by [0,1], where 0 c a n be thought o f as i g n o r i n g the future payoffs w h i l e 1 values future payoffs e q u a l l y w i t h the current p e r i o d (no discounting).  T h i s terminology reflects the fact that firms o n l y have one chance to determine how they w i l l set their prices. ' F O B pricing is equivalent to U n i f o r m P r i c i n g when the firm is exercising market power o n the purchasing side, while U D P is a type o f discriminatory pricing (as the net realization for different customers varies) and is equivalent to U n i f o r m Supplier pricing ( U S ) . ' T h e reservation value is the m a x i m u m value a customer is w i l l i n g to pay or the m i n i m u m price a seller must receive. These values are imposed to provide a b o u n d o n prices under the assumption o f perfectly inelastic demand (supply) curves.  119  T h e most profitable p r i c i n g scheme, regardless o f the f i r m s ' locations, i s to set prices as h i g h as possible; i n other w o r d s , equal to the c u s t o m e r s ' reservation values. C o n s e q u e n t l y , f i r m s w i l l f o l l o w a U n i f o r m D e l i v e r e d P r i c i n g system. W h e n firms are purchasing their inputs, the equivalent system w o u l d i n v o l v e setting the purchase p r i c e as l o w as possible. I f suppliers a l l had to receive the same m i n i m u m p r i c e to supply a g o o d , this w o u l d then y i e l d a U n i f o r m S u p p l i e r p r i c i n g system (where the purchasers w o u l d pay the c o m m o n m i n i m u m p r i c e plus the transportation costs).  A s the exogenous variables change, h o w e v e r , the prices and p r i c i n g systems m a y n o l o n g e r be the i  o p t i m a l c h o i c e . F o r e x a m p l e , as the discount rate decreases, ceteris paribus, firms find that the gains f r o m unilaterally defecting o u t w e i g h those f r o m c o n t i n u i n g to f o l l o w the p r e v a i l i n g prices. T o forestall such actions, firms w i l l l o w e r the price l e v e l to offset the gains f r o m potential defection. E s p i n o s a (1992) then s h o w e d that at certain values and c o m b i n a t i o n s o f these exogenous parameters, the p r i c i n g scheme w o u l d also change as c o l l u s i o n became easier under the alternative p r i c i n g system. S i n c e the potential profits and the payoffs f r o m defecting are different under the t w o p r i c i n g schemes, g i v e n the same parameters, the firms adjusted their prices and chose the strategy that y i e l d e d the highest discounted stream o f future payoffs to forestall the threat of defection. U l t i m a t e l y , conditions become such that the e q u i l i b r i u m price l e v e l reaches a point at w h i c h there are zero or m i n i m a l profits. T h i s point is used as the benchmark for c o m p e t i t i v e prices and price system, and this b e n c h m a r k differs depending o n firm l o c a t i o n .  E s p i n o s a (1992) shows that for c o i n c i d e n t a l l y located firms, the e q u i l i b r i u m outcome for d s 1/2 is for F O B P r i c i n g where the price to the customer consists o f o n l y the transportation costs to that l o c a t i o n (plus any costs i n c u r r e d i n the p r o d u c t i o n o f the good). F o r discount rates greater than 1/2, any price l e v e l or system can be sustained, and g i v e n that U n i f o r m D e l i v e r e d P r i c i n g i s the m o s t profitable, that w i l l be the observed price system.  120  F o r spatially separated sellers, prices w i l l m o v e f r o m U n i f o r m D e l i v e r e d P r i c i n g through F O B p r i c i n g before returning to U n i f o r m D e l i v e r e d P r i c i n g a g a i n as the discount rate increases(the equivalent f o r a purchaser w o u l d be m o v i n g f r o m U n i f o r m S u p p l i e r P r i c i n g system to U n i f o r m P r i c i n g and returning to a U n i f o r m S u p p l i e r system).  H o w e v e r , E s p i n o s a (1992) restricts the f i r m s to the c h o i c e o f o n l y the t w o p r i c i n g systems e v e n i f they are deviating i n the m a i n part o f the m o d e l , w h i c h rules out the N a s h e q u i l i b r i u m d e v e l o p e d i n T h i s s e and V i v e s (1988). W h a t happens, then, i f the m o d e l i s broadened to i n c l u d e this possibility?  The  Importance  of Punishment  Paths  in Determining  Nash  Equilibria  One critical assumption that E s p i n o s a m a k e s i s that the punishment path c h o s e n b y the firms y i e l d s an effective p a y o f f o f zero e c o n o m i c profits (i.e. the firm earns o n l y the n o r m a l rate o f return). A b r e u (1988) shows that any path c a n be sustained i n a perfect e q u i l i b r i u m w h e n firms revert to the worst possible o u t c o m e after a d e v i a t i o n . T o create a punishment path where the payoffs equal zero for eternity, the m o d e l requires the firms to p u n i s h one another b y c o m m i t t i n g to a series o f prices such that i f one firm deviates, the other w i l l price such a w a y i n the next p e r i o d that although it loses m o n e y i n that p e r i o d , the other firm m a k e s zero e c o n o m i c profits. F r o m that p o i n t o n , both firms w i l l m a k e zero e c o n o m i c profits ad infinitum. W h i l e the l i k e l i h o o d o f f i r m s c o m m i t t i n g to such a range o f a c t i o n seems questionable, as noted earlier m a n y o f these m o d e l s have outcomes where these punishment paths are never observed as the threat o f such a c t i o n i s sufficient to forestall any d e v i a t i o n .  E v e n i f the firms d o not revert to the punishment path, their promises to f o l l o w such a path have to be p l a u s i b l e , or sub-game perfect. T h a t i s , i f firms d i d arrive at the p o i n t where they had to f o l l o w the punishment path, w o u l d they prefer to f o l l o w another set o f actions? F o r e x a m p l e , i m a g i n e a firm promises to price b e l o w cost to d r i v e the o v e r a l l price l e v e l d o w n i f another firm deviates f r o m their market-sharing agreement. H o w e v e r , i f the other firm does deviate, then that firm w i l l  find 121  that it incurs losses b y s e l l i n g at such l o w prices, w h i l e the other f i r m w i l l s i m p l y shut d o w n and earn zero profits. T h e firm c o u l d instead p u n i s h the d e v i a t i n g firm b y p r i c i n g at cost, still l o w e r i n g the price l e v e l and h a v i n g the other firm earn zero profits, but n o longer i n c u r r i n g losses itself. Therefore, the threat to price b e l o w cost is not consistent and neither firm w o u l d expect the other to behave i n such a w a y .  It turns out that i n the m o d e l developed by E s p i n o s a (1992) that the chosen punishment path is unsustainable for firms i n separate locations w h e n d i s c r i m i n a t o r y p r i c i n g i s a l l o w e d . F i r m s c a n sustain positive profits w h e n they revert to the N a s h e q u i l i b r i u m i n the one-shot game, and neither firm can d r i v e the other's profits d o w n to zero w i t h o u t consistently i n c u r r i n g losses itself: therefore, such punishment paths n o l o n g e r b e c o m e plausible. F i r m s instead w o u l d revert to the non-cooperative e q u i l i b r i u m after deviation and earn profits o f t/4, and therefore the results f r o m E s p i n o s a ' s (1992) m o d e l n o l o n g e r h o l d and firms n o l o n g e r s w i t c h b a c k a n d forth between different p r i c i n g s y s t e m s .  102  In this case, i t i s the D i s c r i m i n a t o r y P r i c i n g system and the U n i f o r m S u p p l i e r p r i c i n g system that are o f interest, since the first reflects the outcome under d e v i a t i o n (or c o m p e t i t i v e behavior) w h i l e the latter represents the potentially most profitable system and the hypothesized pattern i n the Interior market. I n the first case, the payoffs f r o m d i s c r i m i n a t o r y p r i c i n g are:  N o t e that this assumes that the deviating firm w i l l sets its price fractionally above the other  firm's  prices, and that both firms then revert to the one-shot N a s h e q u i l i b r i u m payoffs o f t/4. I n this case, the payoffs f r o m d e v i a t i o n a l w a y s o u t w e i g h the payoffs f r o m c o o p e r a t i o n w h e n the discount rate is less than 1/2, and w h e n the discount rate is greater cooperation is the preferred strategy. T h i s happens as the gains f r o m d e v i a t i o n are t w i c e that f r o m cooperation w h e n the l o n g term  122  effects o f reverting to the non-cooperative outcome are taken into account. S i n c e any price c a n be sustained w h e n the discount rate i s greater than 1/2, the m a x i m u m profits that c a n be obtained under this p r i c i n g arrangement are R / 2 - t / 4 (the f i r m sets a p r i c e o f zero for the closest supplier).  T u r n i n g to u n i f o r m supplier p r i c i n g , the profits a g a i n f r o m cooperation versus d e v i a t i o n are:  1 \-d  c  . d  d  P  \-d  O n c e again, cooperation c a n be sustained for any discount rate i n excess o f 1/2 and any price c a n be chosen. I n this case, the f i r m s choose the m o n o p s o n y s o l u t i o n , m a x i m i z i n g profits b y setting the purchase price to zero, and r e a l i z i n g profits o f R / 2 - t / 8 . Therefore, the profits are higher than those that c a n be obtained under discriminatory p r i c i n g .  T h e s e results are different f r o m those f o u n d u s i n g the E s p i n o s a (1992) m o d e l w h e n p r i c i n g systems are constrained to f o l l o w either a u n i f o r m d e l i v e r e d price or a u n i f o r m purchase price. I n that m o d e l , f i r m s alternate between the t w o systems, adjusting prices i n response to changes i n the exogenous factors (the discount rate, transportation cost, o r reservation v a l u e , equivalent to the net revenue i n this m o d e l ) .  In a broader sense, the E s p i n o s a (1992) m o d e l i s unrealistic i n its  suggestion f i r m s costlessly s w i t c h between p r i c i n g systems a n d adjust prices smoothly w i t h o u t reverting to what are termed the punishment path strategies. Furthermore, as a theoretical question, it i s not clear w h y f i r m s , i f they do decide to deviate, s h o u l d be constrained to either the F O B or u n i f o r m p r i c i n g systems w h e n the above m o d e l shows that both strategies are d o m i n a t e d b y d i s c r i m i n a t o r y p r i c i n g . A s such, it suggests that E s p i n o s a ' s (1992) m o d e l needs to be m o d i f i e d b y incorporating the possibility o f a reversion to a d i s c r i m i n a t o r y p r i c i n g system. It m a y be the  T h i s shows how dependent the equilibrium may be on the choice o f punishment.  123  case that the p r i n c i p a l result, n a m e l y that u n i f o r m delivered p r i c i n g systems m a y reflect the p o s s i b i l i t y o f either very c o m p e t i t i v e or c o l l u s i v e behavior, is i n c o r r e c t .  103  A l l o w i n g for repeated interaction shows that supra-competitive profits m a y be sustained i f firms c a n choose and f o l l o w a particular p r i c i n g system that y i e l d s greater profits than the n o n cooperative outcome.  I n other w o r d s , the j o i n t l y b e n e f i c i a l outcome i n a prisoner's d i l e m m a that  is not sustainable under one-shot N a s h games b e c o m e supportable w i t h repeated interaction. T h e r e is a range o f potential e q u i l i b r i a , a l l e q u a l l y supportable depending so l o n g as the discount rate firms use exceeds a critical value. T h e most profitable e q u i l i b r i u m is that where firms c a n m i n i m i z e the purchase price and then pay transportation costs; i f suppliers share a c o m m o n m i n i m u m p r i c e , the result w o u l d be a U S p r i c i n g system. H o w e v e r , the m o d e l suggests that firm behaviour and prices c a n change sharply i f the discount rate f a l l s b e l o w the c r i t i c a l v a l u e , and  firms  then m o v e f r o m a tacitly c o l l u s i v e outcome to the non-cooperative outcome. F i r m s then revert to the m o d e l described b y the one-shot game.  S h a p i r o (1989) notes that w h i l e the discount rate i n games o f repeated interaction i s c o m m o n l y used to represent the value firms place o n future actions, it c a n also be thought o f as characterizing h o w q u i c k l y firms m a y respond to one another's actions or the firms' beliefs about h o w l i k e l y the game is to c o n t i n u e .  104  It c a n be s h o w n that the discount rate decreases as the reaction p e r i o d  lengthens or the firm thinks that the game w i l l end sooner than it p r e v i o u s l y b e l i e v e d .  F i n a l l y , this m o d e l brings to the forefront a n important issue that i s t y p i c a l l y glossed o v e r i n most game theory m o d e l s . S i n c e any e q u i l i b r i u m c a n be sustained w h e n the discount rate is greater than  1 0 3  Espinosa (1992) argues that there is no sustainable e q u i l i b r i u m i n F O B prices below a certain discount rate and therefore the e q u i l i b r i u m must take the f o r m o f a u n i f o r m delivered p r i c i n g system. H o w e v e r , under such a system, firms are forgoing potential profits by not charging more to their nearest customers w h i c h they c o u l d do by altering their prices and hence the solution is not a Nash equilibrium.  104  " F o r m a l l y , 6 may be thought o f as the product o f two terms: b=ve' , where v is the hazard rate for the competition continuing (i.e. the probability that the game continues after a g i v e n period, given that is has not previously ended), and e"' is the pure interest component o f the discount factor, w i t h period length T and interest rate i . " (Shapiro 1989:365). iT  T  124  1/2, h o w d o firms arrive at a particular N a s h e q u i l i b r i u m ? I n particular, g i v e n the inherently unstable market areas under a u n i f o r m supplier p r i c i n g system, h o w d o firms arrive at a c o m m o n price? K r e p s (1990: 5 2 9 - 5 3 1 ) , i n his textbook o n m i c r o e c o n o m i c s a n d g a m e theory, discusses this very question:  What's w r o n g w i t h the game theoretic approach?  T h e d i s c u s s i o n above centers o n the (in)ability to m o n i t o r [referring to a lengthy d i s c u s s i o n o f m o d e l s i n v o l v i n g n o i s y market prices a n d whether o r not c h a n g i n g prices reflect deliberate deviations o r d e m a n d shocks]. B u t there i s another p r o b l e m , i n t u i t i v e l y s i m i l a r , to contend w i t h i n applications. W h a t do y o u m o n i t o r ? W h e n w e have s y m m e t r i c firms, i t seems " o b v i o u s " that w e s h o u l d l o o k f o r symmetric e q u i l i b r i a w h e r e i n every f i r m acts i n the same w a y . B u t i n an o l i g o p o l y o f a s y m m e t r i c firms, i t w o n ' t be crystal c l e a r just what is the " r u l e " each i s s u p p o s e d to f o l l o w . . . W e have returned to t w o c l o s e l y related weaknesses o f this approach: T h e t w i n p r o b l e m s o f too m a n y e q u i l i b r i a a n d the selection o f one o f them. C o m p a r e the m o d e l o f this section w i t h the C o u r n o t , o r B e r t r a n d , o r v o n S t a c k e l b e r g m o d e l . I n the three classic m o d e l s , a definite p r e d i c t i o n i s made about what w i l l happen. O n e c a n (and w e do) argue that this definiteness arises s p e c i o u s l y . Insofar as the repeated p l a y m o d e l is the right m o d e l , the classic m o d e l s m a k e an ad hoc assumption about r i v a l s ' conjectures, w h i c h is v i r t u a l l y equivalent to assu ming w h i c h e q u i l i b r i u m pertains. U n l e s s there is some reason g i v e n f o r the a d h o c assumption, n o t h i n g has been g a i n e d except perhaps to e x p l a i n what sort o f conjectures l e a d to certain e q u i l i b r i u m outcomes.... A second l a c u n a i n the theory is apparent w h e n w e e x a m i n e c l o s e l y the c l a i m that s p e c i f y i n g institutions helps us to understand outcomes, at least i n n o i s y environments. T h i s m a y be true as far as it goes...But it leaves o p e n the question, W h e r e d i d the institution c o m e f r o m ? M o r e generally as w e l o o k across industries, do variations i n the "rules" reflect uncontrollable environmental differences, or are institutions the result o f some c o n s c i o u s o r unconscious c h o i c e s by participants? W e w i l l not resolve these p u z z l e s at this point. I n fact, w e w o n ' t resolve them i n this b o o k at a l l ; their f u l l resolutions are o v e r the h o r i z o n o f e c o n o m i c theory at this point."  In this case, the influence o f government p o l i c y m a y w e l l p r o v i d e the m i s s i n g pieces identified by K r e p s (1990) o n h o w a particular e q u i l i b r i u m m a y be sustained. T h i s m o d e l shows that w h e n firms^an coordinate their actions under certain c o n d i t i o n s , i t m a y be possible to sustain supra-competitive outcomes. H o w e v e r , a characteristic o f such  125  e q u i l i b r i u m is that i f they are disturbed, the reversion to m o r e competitive behavior can happen q u i c k l y and prices c a n change s i g n i f i c a n t l y .  F i g u r e 2 0 s h o w s several different p r i c e series for residual w o o d c h i p s i n the B C Interior. T h e first, Actual, is the average p r i c e p a i d to s a w m i l l s i n the Interior o v e r the study p e r i o d (the data used to derive these series i s discussed m o r e f u l l y i n the next chapter). T h e next t w o series illustrate the non-competitive and c o m p e t i t i v e outcomes suggested b y the m o d e l .  T h e next series, Percentage, is constructed b y t a k i n g 9% o f the s e l l i n g p r i c e o f p u l p , reflecting the use o f government-mandated m i n i m u m p r i c i n g restrictions d u r i n g the i n i t i a l development o f the market through the 1970s, and i s meant to reflect non-competitive price-setting.  T h e f i n a l series, Margin, is constructed by deducting cash manufacturing costs ( c h e m i c a l s , labor, overhead, and energy) f r o m the s e l l i n g p r i c e o f p u l p , adjusted for y i e l d for a kraft p u l p m i l l , and is meant to reflect competitive p r i c e - s e t t i n g .  105  I f w e assume that p u l p m i l l s  face constant m a r g i n a l costs, Margin then provides a measure o f the m a r g i n a l net revenue product value o f w o o d chips w h i c h w o u l d equal the price i n c o m p e t i t i v e markets ( A r m s t r o n g 1975). T h i s has also been the approach used i n other studies to estimate the (imputed) value o f p u l p w o o d ( N a u t i y a l et a l . 1995, R u n y o n 1983).  F i g u r e 2 0 shows that the actual prices c l o s e l y track the f i x e d percentage o f the p u l p price over m u c h o f the time p e r i o d , and then m o r e c l o s e l y m a t c h the series d e r i v e d f r o m net revenues. T h i s i s consistent w i t h the idea o f f i r m s f o l l o w i n g a specific p r i c i n g system and then reverting to the sub-optimal outcome as the fundamental d y n a m i c s o f the prisoner's d i l e m m a reassert themselves.  ' Costs were conservatively set at $400 per metric tonne to include overhead and delivery costs but to exclude fibre costs, based o n reported costs for the Interior p u l p industry derived from Table A l 13, B C M O F (1995). N o allowance was made for inflation. 126  Figure 20. Actual and Constructed Price Series for Wood Chips in the BC Interior  W h i l e the m o d e l shows that a m o v e towards more competitive b e h a v i o u r w i l l be m a r k e d b y higher prices, the increase i n prices observed i n F i g u r e 2 0 m a y reflect other forces at w o r k i n the market. I n order to test the m o d e l , it i s necessary to e x a m i n e whether or not the increase i n price levels can be attributed to the change i n f i r m behaviour noted i n the Interior. In a d d i t i o n , the m o d e l also shows that the p r i c i n g pattern o f u n i f o r m s a w m i l l prices observed i n the past cannot be e x p l a i n e d b y competitive b e h a v i o u r . F u r t h e r m o r e , the m o d e l shows that more competitive behaviour w i l l l e a d to a change i n spatial p r i c i n g patterns.  F i n a l l y , the m o d e l suggests that as c o m p e t i t i v e behaviour increases, interaction  between f i r m s m a y also increase since they w i l l n o w use the other firms prices (or estimates o f the other firms values) i n determining their o w n prices. T h e next chapter proceeds to test these hypotheses to see whether the changes i n prices and p r i c i n g practices are consistent w i t h the m o d e l o u t l i n e d above.  127  4. Tests of Price Discrimination in the Wood Chip Market in the British Columbia Interior T h i s chapter e m p i r i c a l l y tests f o r the presence o f market p o w e r u s i n g t w o approaches. T h e first relies o n a c o m p a r i s o n o f the Interior residual w o o d c h i p market w i t h other markets, and tests for differences between market price levels. T h e second approach tests whether changes i n prices and the pattern o f prices at the firm l e v e l m a t c h those predicted b y the m o d e l as firms m o v e towards m o r e c o m p e t i t i v e behavior.  Tests  of Market  Price  Levels  T h e i n t u i t i o n b e h i n d the first approach is the ' L a w o f O n e P r i c e ' , w h i c h says that f o r units o f an "identical good...[one price] is indeed a l o g i c a l consequence o f e c o n o m i c rationality and competitive markets."(Caves, F r a n k e l , a n d Jones 1990). T h i s l o g i c underlies spatial e q u i l i b r i u m m o d e l s , where regional markets c l e a r as arbitrage dictates that goods m o v e between markets to the point where e q u i l i b r i u m prices i n each market w i l l differ o n l y b y the transportation costs between each market. I f the difference i n e q u i l i b r i u m price between a market is less than the transportation cost to any other market, that means that demand a n d supply w i l l equilibrate w i t h i n that one market. I n the absence o f market p o w e r o r any k i n d o f export restrictions one w o u l d a priori expect a l l s a w m i l l s to receive the same price for their w o o d chips, less the difference i n transportation costs between their l o c a t i o n and the market w i t h the highest e q u i l i b r i u m price.  T h e m a i n difficulty o f these approaches is separating the effect o f market p o w e r f r o m other factors that m a y affect l o c a l markets, such as changes i n r e g i o n a l d e m a n d , s u p p l y , o r technology that w i l l affect prices. F o r e x a m p l e , changes i n the d e m a n d f o r p u l p c a n affect  128  the p r i c e o f w o o d chips, w h i l e the a d o p t i o n o f different technologies, such as C T M P , c o u l d also be expected to affect the d e m a n d and hence price for w o o d c h i p s .  1 0 6  It is also possible to use this reasoning to e x a m i n e the pattern o f prices p a i d i n l o c a l markets. W h e n f i r m s are located c o i n c i d e n t a l l y , the u n i f o r m supplier p r i c i n g system means that a purchaser w i l l utilize more distant chips that are m o r e costly than nearby l o c a l chips i f l o c a l markets are unable to satisfy their demand. U s i n g data o n prices and v o l u m e s , i t is possible to calculate the difference between what a purchaser actually p a i d for their chips and what they w o u l d have p a i d had they been able to acquire the same amount o f fibre at a l o w e r cost. U n d e r a U n i f o r m S u p p l i e r p r i c i n g system, a p u l p m i l l c o u l d save m o n e y b y n o longer p u r c h a s i n g chips f r o m its m o r e distant suppliers and r e p l a c i n g t h e m w i t h chips f r o m a closer s a w m i l l (since the c h i p price w o u l d be the same but the p u l p m i l l w o u l d save o n transportation costs). H o w e v e r , that s a w m i l l is s u p p l y i n g the r i v a l purchaser and the f i r m has to w e i g h the benefit f r o m r e d u c i n g its fibre cost against the p o s s i b i l i t y that such action m a y l e a d to higher prices (and both purchasers w i l l end up p a y i n g m o r e i n the l o n g run). T h e potential gains are calculated b y s u m m i n g up the cost o f a c q u i r i n g a n equivalent amount o f fibre f r o m the closest s a w m i l l s and then d e d u c t i n g the cost o f supply f r o m e x i s t i n g suppliers u s i n g i m p u t e d transportation c o s t s .  107  T a b l e 1 1 shows the actual differences  for t w o p u l p m i l l s i n the P r i n c e G e o r g e Forest R e g i o n for selected months (the months were chosen for a representative range o f suppliers and to c o i n c i d e w i t h the p e r i o d under w h i c h it i s assumed f i r m s were f o l l o w i n g a U S p r i c i n g system). T h e differences are considerable, and are the m o r e s t r i k i n g for their persistence. S u c h differences w o u l d not be expected to last under the assumption o f competitive b e h a v i o u r .  ' It should be noted that the prices observed i n F i g u r e s 13 a n d 14 are inconsistent with such models. However, as noted i n Chapter 3, spatial price discrimination is not inconsistent with models of competitive behavior, especially at the f i r m level. ' Transportation costs were assumed to be constant at 15 cents per B D U , and it was assumed that the price paid to a competitor's supplier was infinitesimally greater. S u p p l y was aggregated based on distance, m o v i n g from the closest to next closest supplier to satisfy the reported purchases for that period. These estimates are conservative, as not all suppliers w o u l d be listed for each month. 129  Table 11. Potential Gains in the Prince George Forest Region from Changing Suppliers January 1988  November 1989  June 1990  August 1993  Purchaser A  $305,000  $370,000  $615,300  $160,000  Purchaser B  $760,000  $526,400  $545,700  $130,000  Figure 21 shows  quarterly p r i c e i n d i c e s f o r w o o d chips o v e r a ten year p e r i o d i n three  distinct markets: the B C export market ( N o r t h V a n c o u v e r ) ; the N o r t h e r n Interior market (otherwise k n o w n as the P r i n c e G e o r g e market); and the Puget S o u n d m a r k e t for D o u g l a s f i r chips i n the P a c i f i c N o r t h w e s t . T h e w o o d c h i p s s o l d i n these three markets are very s i m i l a r ; i n fact, some o f the chips s o l d i n N o r t h V a n c o u v e r originate f r o m the N o r t h e r n Interior.  108  S i m i l a r species i n terms o f quality are used (it should be noted that D o u g l a s - f i r  is regarded as slightly less desirable than the export m i x o f chips s o l d i n N o r t h V a n c o u v e r , w h i c h is at least 5 0 % spruce and the rest p i n e and true firs). Therefore, w h i l e actual prices i n these regions w o u l d differ due to r e g i o n specific transportation costs and other costs o f p u l p p r o d u c t i o n , s u c h as l a b o r and energy, relative p r i c e l e v e l s s h o u l d be s i m i l a r , a c c o r d i n g to the ' L a w o f O n e P r i c e ' .  H o w e v e r , there is one substantial difference between these three markets. T h e r e are n o restrictions o n the export o f w o o d chips f r o m the U S ; consequently, any s u p p l i e r is free to sell their chips into the w e l l - d e v e l o p e d export market that exists o n the W e s t C o a s t .  1 0 9  W i t h i n B C , restrictions o n c h i p export restrict the p o s s i b i l i t y o f s u c h arbitrage, but the participation o f l i m i t e d v o l u m e s i n the export market does offer a measure o f the value o f those c h i p s . E x p o r t v o l u m e s ranged between 6 % and 1 5 % o f total Interior p r o d u c t i o n o v e r the p e r i o d 1987 through 1995 for w h i c h data was a v a i l a b l e (see  !  Table 3 and Table 4).  T h e prices i n a l l three markets were comparable i n 1986.  ' T h e Puget Sound market is felt to be very competitive, as suppliers are free to sell into the export market i f they are unhappy w i t h the price offered by local purchasers. ( E k s t r o m , 1996).  130  A w e l l - k n o w n e x a m p l e o f market comparisons has been w o r k e x a m i n i n g the i m p a c t o f l o g export restrictions o n l o g prices o n the B C Coast. M a r g o l i c k and U h l e r (1992) s h o w e d that export restrictions have depressed d o m e s t i c prices i n the V a n c o u v e r l o g market, c o m p a r e d to l o g prices i n the U S l o g market i n Puget S o u n d .  F i g u r e 2 1 s h o w s the trend f o r prices i n Puget S o u n d , the export market, and the B C Interior, based o n C a n a d i a n dollars. P r i c e s i n Puget S o u n d c l o s e l y f o l l o w export prices, reflecting the interaction between those t w o markets, w h i l e B C Interior prices f o l l o w e d both markets until 1990 w h e n price levels started increasing i n those markets but r e m a i n e d flat and e v e n trended d o w n w a r d s .  1 1 0  Interior prices continued to diverge f r o m prices i n  the Puget S o u n d and export market u n t i l 1994, at w h i c h p o i n t interior price l e v e l s rose r a p i d l y , and prices i n a l l the markets were a g a i n m o v i n g i n tandem. T h i s evidence suggests that there are factors at w o r k i n the Interior market not present i n the other t w o markets.  ' T h e increase i n the late 1980's has been generally attributed to concerns about reduced harvest levels i n the Pacific Northwest due to the spotted o w l . 131  Figure 21. Relative Price Changes in Three Wood Chip Markets 350  0 I i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i 1986Q1 1988Q1 1990Q1 1992 OJ 1994 QJ 1996Q1 - O — Export U S D-Fir Prince George SPF  Source: W o o d F i b r e N o r t h w e s t , quarterly reports  Figure 22 l o o k s at the relative production o f chips i n the Interior to e x a m i n e the possibility that there m a y have been some region-specific supply shock, or that the pattern o f prices m a y m e c h a n i c a l l y reflect change i n p u l p prices due to f o r m u l a p r i c i n g . It can be seen that c h i p production has r e m a i n e d relatively constant over the eight-year p e r i o d .  Figure 22 also shows quarterly i n d i c e s for Interior w o o d c h i p prices a l o n g w i t h p u l p prices for 1987 through 1996, again based o n C a n a d i a n dollars. T h e sharp increase i n c h i p prices starting i n the second quarter o f 1994 is i m m e d i a t e l y apparent (prices nearly doubled), w h i l e p u l p prices d i d not exceed the h i g h f r o m the previous c y c l e until the b e g i n n i n g o f 1995, nearly one year later.  132  Figure 2 2 . Relative Change in Prices and Production 1 9 8 7 - 1 9 9 6 o  1  3 0 0  :  i 0  I  I  1987:3  I—I  I  I  i—i—i—I  1989:1  I—I  I  I  I—I  I  I  I  I—I  I  I  i—r—i—n—I  1990:3 1992:1 1993:3 -Interior Price —B— - Export Price - Pulp Price - Interior Production  I  I  I—I  I  I  1995:1  (Source: W o o d F i b r e N o r t h w e s t , C O F I )  A r e there other factors specific to the Interior that m i g h t e x p l a i n the different price patterns? A s noted i n  Table 6, w i t h the exception o f the e x p a n s i o n i n p u l p capacity at C e l g a r ,  annual p u l p capacity i n the Interior has changed little since 1989-90, the last h i g h point i n the p u l p price c y c l e . There have not been any recent entrants into the Interior industry. T h e o n l y p u l p m i l l built since 1987, the L o u i s i a n a P a c i f i c p u l p m i l l i n C h e t w y n d , relies s o l e l y o n aspen r o u n d w o o d c h i p s . T h e r e were no significant changes i n o w n e r s h i p w i t h i n the industry over the same period. P o l i c y changes regarding stumpage and e n v i r o n m e n t a l regulation postdate the change i n prices (the i m p a c t these change m i g h t have o n future supplies is discussed m o r e f u l l y i n C h a p t e r 5 ) .  Therefore, at the t i m e w o o d c h i p prices shot up, industry structure had r e m a i n e d remarkably stable and the industry had not yet faced any significant p o l i c y changes. Furthermore, p u l p prices and c h i p p r o d u c t i o n l e v e l s i n the Interior c h i p market were not  133  substantially different than they had been i n p r e v i o u s periods. T h i s suggests that changes i n industry structure or regional d e m a n d and supply are u n l i k e l y to e x p l a i n the change i n Interior prices.  Testing  for Changes  in Market  Price  Levels  T h e existence o f an export market provides the means to test whether the hypothesized change i n market b e h a v i o u r explains the increase b y u s i n g the export market as a measure o f the true m a r g i n a l v a l u e o f w o o d c h i p s . T h i s approach f o l l o w s M a d h a v a n et a l . (1994), w h i c h e x a m i n e d the market for d a i r y products i n the U S and f o u n d significant differences between the m a r g i n for t w o types o f m i l k (equivalent i n quality) s o l d b y dairy cooperatives before and after an antitrust decree. B y a s s u m i n g that prices i n both the export and Interior market w i l l respond e q u a l l y to any o v e r a l l changes i n w o r l d d e m a n d for p u l p , expressed as changes i n the price o f p u l p , it i s possible to d i s t i n g u i s h to what extent factors specific to the Interior market are i n f l u e n c i n g prices i n the Interior market.  In the case o f the Interior market, w e are interested i n testing t w o variables that m a y e x p l a i n differences i n price levels w h i l e h o l d i n g the effect o f p u l p prices constant. A l l o f the variables are quarterly. T h e first variable o f interest is Excess, w h i c h equals the p r o d u c t i o n o f p u l p fibre w i t h i n the N o r t h e r n Interior less c o n s u m p t i o n w i t h i n the r e g i o n .  1 1 1  The  r e g i o n i s a net exporter o f p u l p fibre so that p r o d u c t i o n h i s t o r i c a l l y exceeds c o n s u m p t i o n w i t h i n the region. T h e difference between the t w o is a measure o f the relative a v a i l a b i l i t y o f residual chips; increases i n d e m a n d o r decreases i n s u p p l y w o u l d decrease the amount o f available fibre, w h i c h w o u l d be expected to l e a d to price increases i n the Interior under competitive conditions.  111  T h i s data was derived from the C O F I C h i p A u d i t Task force, described i n both the data appendix and i n Chapter 6. T h e data set covers production and consumption o f all p u l p fibre, i n c l u d i n g roundwood chips, o n a quarterly basis w i t h i n the northern Interior (the Prince George, Prince Rupert, and Cariboo Forest Regions). T h i s is the same region where chip prices first started to increase. 134  T h e second variable o f interest i s Change. It i s constructed as a d u m m y variable designed to measure the presumed change i n market b e h a v i o u r between the t w o periods, and equals 1 after the first quarter o f 1994 (as F e b r u a r y 1994 w a s the m o n t h the c h i p s were put u p f o r b i d ) . A n y change i n the behaviour o f relative prices i n these t w o markets after this date not p i c k e d up b y the other variables w i l l show up as a significant coefficient o n this variable.  T h e third variable i s Pulp, w h i c h equals the v a l u e o f bleached kraft p u l p exported f r o m B C for that quarter, a n d accounts f o r changes i n the price firms p a y i n the Interior due to f o r m u l a p r i c i n g . T h e fourth a n d final variable i s Time, to a l l o w f o r the p o s s i b i l i t y that there was a d y n a m i c component affecting prices not p i c k e d up i n the other v a r i a b l e s .  112  T h e dependent variable is Margin, a n d equals the E x p o r t p r i c e less the Interior price, d i v i d e d b y the export price. It therefore shows the difference between the t w o p r i c e levels expressed as a percentage o f the export p r i c e , a n d ranges between 0 ( w h e n the t w o prices are equal) to 1 ( w h e n the domestic price equals zero). T h e higher the m a r g i n , then, the greater the discrepancy between prices i n the t w o markets.  E q u a t i o n (1) shows the m o d e l  that w a s estimated. T h e data used i n the estimation are discussed i n the section Allowing  firm interaction.  (1)  Margin = j8 + j8, x Excess +fi t  0  t  x 2  Time + j8 x Pulp + /3 x Change + s 3  t  4  t  Results from Testing for Changes in Price Levels T a b l e 12 reports the results o f a regression corrected f o r auto-correlation. W h i l e the coefficients for Time, Pulp , a n d Change were a l l significant, the measure o f l o c a l d e m a n d relative to supply, Excess, w a s insignificant although i n the correct d i r e c t i o n (since decreased availability i n the l o c a l market should raise the price i n the l o c a l market relative to  135  the export market and therefore decrease the m a r g i n ) . T h i s suggests that changes i n l o c a l d e m a n d relative to supply d o not e x p l a i n differences i n price levels; rather, the explanation lies i n a change i n market b e h a v i o u r .  Table 12. Margin as a Function of Demand and Market Power, n=30 Variable Coefficient t-ratio  Constant  Excess  .767  -3.49*10  Time 3  (.26)  (4.52)  4.49*10^ (2.16)  Pulp  Change  -5.17*10"*  - 3 . 3 4 * 10  (7.16)  (1.98)  1  J  Critical value of t for 95% level of confidence=1.96 Durbin H Statistic=.58; R =.91 J  T h e s i g n o f the Change variable i s consistent w i t h the hypothesis; a m o v e towards m o r e competitive behaviour w o u l d be expected to l e a d to higher prices i n the domestic market relative to the export market, l e a d i n g to a decrease i n the m a r g i n . I n a d d i t i o n , the positive and significant s i g n o n the variable Time shows that the m a r g i n was g r o w i n g over time (this c a n be seen i n Figure 21). T h e negative s i g n for Pulp suggests that the m a r g i n decreased as the p r i c e o f p u l p rose (although this effect was a n order o f magnitude less). T h i s suggests that the difference i n price levels between the t w o markets shrinks i n relative terms as the o v e r a l l price l e v e l rises.  Table 12 shows that there w a s a significant shift i n relative price levels i n the Interior and export markets between the first period c o v e r i n g prices through 1987 and the first quarter o f 1994, a n d the second p e r i o d c o v e r i n g the s e c o n d quarter o f 1994 through 1996. T h e s e t w o periods were chosen to reflect h y p o t h e s i z e d differences i n f i r m b e h a v i o u r based o n differences i n h o w contracts were put u p for b i d a n d signed w i t h i n the Interior market. P r i c e s i n the Interior market d u r i n g the second p e r i o d m o v e d closer towards the export  112  Excess is based o n the consumption and production o f pulp fibre w i t h i n the Central and Northern Interior (also k n o w n as R e g i o n One).  136  price, consistent w i t h the i d e a o f increased c o m p e t i t i o n i n the Interior market. C a n more competitive behavior also be seen at the firm l e v e l ?  Tests  of Firm  Prices  and Pricing  Patterns  T h e m o d e l d e v e l o p e d i n C h a p t e r 3 s h o w e d h o w a specific p r i c i n g pattern, n a m e l y a U n i f o r m S u p p l i e r p r i c i n g system, where the price p a i d to suppliers w a s the same regardless o f their l o c a t i o n , c o u l d l e a d to greater profits than m o r e competitive b e h a v i o u r . T h e m o d e l also s h o w e d that m o r e competitive behavior was associated w i t h increasing prices and a change i n the spatial pattern o f prices. T h e first part o f this section tests t w o hypotheses: first, prices have been set i n the Interior as a percentage o f the p u l p price a n d have been constant across s a w m i l l s ; and second, there was a significant change i n prices and p r i c i n g patterns. D u e to data l i m i t a t i o n s , h o w e v e r , the p e r i o d tested o n l y covers the first few months o f the hypothesized change i n market b e h a v i o u r .  113  T h e second set o f tests are d e r i v e d f r o m the other predictions made b y the m o d e l and rely o n changes i n firms' prices relative to other prices and exogenous changes i n the value o f w o o d chips.  Testing  for Formula  Pricing  If purchasers are indeed setting prices a c c o r d i n g to a c o m m o n U n i f o r m S u p p l i e r p r i c i n g system, then the price p a i d b y i n d i v i d u a l purchasers to their suppliers s h o u l d reflect this practice. S p e c i f i c a l l y ,  (2) P ^ V  113  +  Information identifying individual suppliers and purchasers was not available due to a change i n data collection methods.  137  T h e p r i c e p a i d to s a w m i l l s , P , i s d e r i v e d f r o m the presumed f o r m u l a w h i c h is assumed to equal a fixed percentage o f the p u l p m i l l ' s net s e l l i n g p r i c e , R .  1 1 4  Transportation costs, t, are replaced b y distances i n the estimation, w h i c h assumes constant per unit transportation costs per measure o f distance across the region. I f p u l p m i l l s i n the Interior have practiced third degree price d i s c r i m i n a t i o n and set prices o n a u n i f o r m s a w m i l l basis then the coefficient o n distance s h o u l d be zero. P , is the p r i c e o f l u m b e r , and is t  i n c l u d e d to test whether l u m b e r m a y influence c h i p prices (see C h a p t e r 3 f o r a d i s c u s s i o n o f h o w l u m b e r prices m a y p r o v i d e a floor). I n a d d i t i o n , a t i m e trend is incorporated.  T h e m o d e l contains t w o distinct breaks, separating the study p e r i o d into three intervals. T h e first i n t e r v a l covers the period f r o m D e c e m b e r 1987 through the end o f 1989, w h e n the p r o v i n c i a l government was t r y i n g to raise c h i p prices i n the Interior market through m o r a l suasion (see the section entitled " C h i p D i r e c t i o n P o l i c y D r o p p e d " i n C h a p t e r 2). W i t h i n this p e r i o d , it i s assumed p u l p m i l l s are f o l l o w i n g f o r m u l a p r i c i n g but m a y have responded differently ( i f at all) to government pressure to raise prices. T h e second i n t e r v a l covers the p e r i o d f r o m A p r i l 1989 through February 1994, d u r i n g w h i c h p e r i o d p u l p m i l l s were presumably p r a c t i c i n g f o r m u l a p r i c i n g w i t h o u t any government pressure. T h e third i n t e r v a l comes after the change i n purchaser and supplier behavior i n F e b r u a r y , 1994, w h e n c h i p s were put up for b i d , and the purchasers were d e v i a t i n g f r o m the o l d f o r m u l a p r i c i n g system.  Data T h e data set for this estimation consists o f 2 , 5 6 2 i n d i v i d u a l arms-length transactions for w o o d chips i n the Interior o f B r i t i s h C o l u m b i a for the p e r i o d D e c e m b e r 1987 to J u l y 1994. Purchasers i n c l u d e ten o f the p u l p m i l l s w i t h i n the r e g i o n and the largest purchasers o f  114  Recall that the reservation value i n the models discussed i n Chapter 3 provided an upper or lower b o u n d . T h e results for the U n i f o r m Supplier model showed that a non-competitive e q u i l i b r i u m could be sustained i f firms were able to agree o n a c o m m o n price that fell w i t h i n the range o f reservation values ( i n the case o f residual chips, this w o u l d be a m i n i m u m that sawmills w o u l d need to receive to stay open and the m a x i m u m the pulp m i l l w o u l d be w i l l i n g to pay). Needless to say, these values are constantly changing and the range can be quite large. 138  residual chips f r o m 5 2 s a w m i l l s w i t h i n the r e g i o n . B o t h prices and quantities are reported for each transaction but not a l l transactions are necessarily reported for each m o n t h . H o w e v e r , each p u l p m i l l and s a w m i l l i s represented i n the data set. Several months o f data i n 1988 and 1989 are m i s s i n g , so the total n u m b e r o f months c o v e r e d is 6 8 .  1 1 5  T h e dependent variable is the observed price o f residual chips i n C a n a d i a n $ per B o n e D r y U n i t i n the transaction, F O B the s a w m i l l , for purchasers located i n the Interior. Distance i s measured between the s a w m i l l and the purchaser i n kilometers, w h i l e Pulp is the average m o n t h l y gross price reported for bleached K r a f t p u l p exported f r o m B r i t i s h C o l u m b i a b y Statistics C a n a d a i n $ per metric tonne. Before i s a d u m m y variable for the p e r i o d January 1987 to M a r c h 1989, s i g n i f i e d as P e r i o d I, and i s c h o s e n to c o i n c i d e w i t h government intervention to raise c h i p prices i n the Interior i n the spring o f 1 9 8 9 .  116  After i s a d u m m y  v a r i a b l e for the p e r i o d F e b r u a r y 1994 to J u l y 1994, s i g n i f i e d b y P e r i o d III, a n d i s c h o s e n to c o i n c i d e w i t h the hypothesized change i n f i r m behavior (again distinguished b y a change i n h o w chips were bought f o l l o w i n g the c h i p s put up for b i d i n Q u e s n e l ) . B o t h Before and After are interactive d u m m i e s w i t h the lagged p u l p price, w h i l e o n l y After i s interactive w i t h distance. Lumber is the p r i c e per thousand b o a r d feet o f S P F 2 x 4 l u m b e r , r a n d o m length, Standard and Better, f r o m the Interior f r o m M a d i s o n ' s C a n a d i a n L u m b e r Reporter, w h i l e Time i s a m o n t h l y time trend that increases b y one w i t h each m o n t h o v e r the sample period. A l l prices are i n n o m i n a l C a n a d i a n dollars, reflecting the fact that these were the prices f i r m s were u s i n g i n their d e c i s i o n - m a k i n g .  117  E q u a t i o n (3) shows the exact m o d e l where A . . . J represent ten purchasers i n the interior (all p u l p m i l l s ) , w i t h i the c h i p purchases f r o m that i n d i v i d u a l s a w m i l l .  115  A p p e n d i x 1 provides a more detailed analysis o f this data set.  1 1 5  A s discussed i n the section entitled Chip direction policy dropped i n Chapter 3.  1 1 7  T h e lumber price was reported i n U . S . dollars and converted into Canadian dollars.  K  =  Po + PulPt-i {Pi + P x  x 2  Before + j8 x After) + Distance x 3  u  (fi + 6 x A/ter) + j8 x Lumber + /J x Twze A  Model  S  E s t i m a t i o n  6  a n d  D i s c u s s i o n  t  of  7  the  R e s u l t s  T h e m a i n purpose o f this m o d e l i s to determine whether a u n i f o r m p r i c i n g system was practiced w i t h i n the Interior and the relationship between product prices and c h i p prices. T a b l e 1 3 reports the results o f estimating equation (3) f o r each o f the ten purchasers separately w i t h t-ratios reported b e l o w the estimated coefficients, as w e l l as s u m m a r y statistics. Coefficients significant at the 9 5 % l e v e l are i n b o l d .  T h e equations have been corrected for autocorrelation where present. T o preserve the confidentiality o f the i n d i v i d u a l purchasers, o n l y the difference i n the percentage o f the p u l p price between p e r i o d II (the longest interval i n the data set, c o v e r i n g A p r i l 1989 to February 1994) and the t w o f l a n k i n g periods are reported (these periods are m a r k e d I and III) respectively. T h e purchasers include: C a r i b o o P u l p and Paper, C a n f o r , C e l g a r , C r e s t b r o o k , E u r o c a n , F i n l a y , F l e t c h e r C h a l l e n g e , N o r t h w o o d , Q u e s n e l R i v e r P u l p , and Weyerhaeuser. A s an additional precaution, i n d i v i d u a l sample sizes are not reported: the smallest sample contained 4 5 data points, w h i l e the largest sample contained 6 2 4 .  T h e first set o f coefficients, P r i c e o f P u l p , c a n be interpreted as expressing the c h i p p r i c e as a percentage o f the p u l p p r i c e . F o r e x a m p l e , purchaser A increased the price p a i d b y . 6 0 % o f the price o f p u l p between P e r i o d I and P e r i o d II, and then b y 3 . 4 4 % b e t w e e n P e r i o d II and P e r i o d III. F o r a l l purchasers, the p r i c e o f p u l p was h i g h l y significant, and ranged b e t w e e n 7 . 2 % to 9 . 9 1 % f o r the i n d i v i d u a l purchasers, w i t h a n average o f 8.8% f o r nine o f the ten purchasers i n p e r i o d I I .  1 1 8  Purchaser F was excluded due to an estimate four times greater than that o f the other firms. T h e higher estimate offsets the significantly larger negative constant term for this firm. T h e sample size for this f i r m was quite small (N<50) reflecting the fact that they are not a major purchaser o f chips i n the Interior market, and these results may reflect a different pricing practice.  5  140  Table 13. Estimating Wood Chip Prices as a Function of Product Prices and Distance Paid by Pulp Mills in the B C Interior Firm  I A B  ;  c  •  D  i  E  |  F  1  G  1  H  |  J*"  -.6 (1.12) -.5 (1.14) -.5 (.71) -.1 (.15) -1.0 (1.46) na  -1.9 (1.71) -.2 (.18) -.9 (1-92) .2 (.33)  Price of Pulp  Distance  Lumber  Time  (% of pulp price)  cents/km  cents/Mbf  cents/ month  II  III  III  *  3.44 -.9 (4.28) (1.00) 4.47 -.1 * (-22) (11.51) (6.90) 4.0 -3.5 * (8.08) (4.84) (3.73) 4.9 -2.4 * (5.61) (3.86) (11.15) 8.4 .3 * (.43) (7.56) (11.75) 5.1 .2 * (.15) (5.23) (2.51) (9.30)  * (3.85)  *  (5.07)  *  (10.23)  *  na  R  2  |  III 3.1 (1.72) 2.0 (1.56) -2.4 (1.07) .8 (.30)  -8.6 (5.24) -5.2 (1.51) na  6.3 (6.46)  -22.2 (2.10) .9 (.59)  -2.1 (1.32)  -2.2 (4.00)  -7.5 (2.56) 4.7 (2.55)  .3 (1.07)  -.9 (.75)  4.2 (3.76) (11.32)  Constant  -.9 (1.44) -.5 (.55) -2.1 (.15) -1.3 (1.28) -1.4 (.13) -5.6 (1.85)  .27 (2.30) .17 (1.82) .31 (2.00)  2.2 (.87) 1.8 (1.02)  .05 (.24) .06 (.29) -.04 (.36) .15 (1-49)  3.8 (3.23) -1.0 (.91)  .26 (2.36) -.11 (.82)  -3.22 (.29) -1.72 (.20) -7.08 (.54) -7.95 (.81) 18.16 (1.62)  1.92 (3.57) 183.65 (3.53) 27.60 (1.19) .58 (.03) -5.76 (.58) -10.04 (1.05)  .56 |  .48  j j j  .73  |  .63  j  .39 .38  .48 ! .68 .61 • .73 :  * suppressed 1 na=not available I **current i ***iagged two periods i Critical value for t for 95% level of confidence = 2.306  E i g h t o f the purchasers s h o w e d a n increase i n the price p a i d between P e r i o d I a n d P e r i o d II; h o w e v e r , the difference w a s o n l y significant f o r purchaser I. E i g h t o f the purchasers s h o w e d significant increases i n the price p a i d between P e r i o d II a n d P e r i o d III, w h i l e purchaser I s h o w e d a slight but insignificant decrease.  B e c a u s e the p u l p price used is based o n the price at the point o f export, a n d it c o u l d not be specified h o w l o n g the t i m e l a g w o u l d be between what firms w o u l d r e c e i v e versus w h e n p u l p w o u l d be shipped, v a r i o u s time lags w e r e u s e d to calculate w h i c h p e r i o d w o u l d p r o v i d e a better fit. In terms o f t i m i n g , the p u l p p r i c e l a g g e d one p e r i o d p r o v i d e d the best  141  fit. T h e t w o exceptions w e r e purchaser I, where the current p e r i o d p r o v i d e d the best fit, and purchaser J , where the price t w o months ago p r o v i d e d the best fit. T h i s m a y be due to differences f o r those purchasers between processing a n d s h i p p i n g o r m a y reflect different p r i c i n g practices.  T h e second set o f coefficients i n T a b l e 1 3 show h o w the prices p a i d to s a w m i l l s differed b y their l o c a t i o n ; for e x a m p l e , s a w m i l l s w h i c h s o l d to purchaser A f o u n d that the price they r e c e i v e d w a s l o w e r b y .9 cents per B D U for every k i l o m e t e r o f distance between them a n d purchaser A d u r i n g P e r i o d s I-II, w h i l e i n the P e r i o d III the p r i c e rose b y 2.2 cents per B D U per k m (3.1 cents -.9 cents).  T h r e e firms, C , D , a n d I p a i d prices d u r i n g the first  t w o periods that significantly f e l l w i t h distance; h o w e v e r , the change i n price w a s m u c h less than the actual cost o f transportation (prices dropped between 2 a n d 4 cents per B D U per kilometre but the actual cost o f transportation i s c l o s e r to 15 cents per B D U per kilometre). T h i s m a y reflect a historic p r i c i n g practice i n v o l v i n g the treatment o f freight costs under the o l d stumpage system; freight costs i n excess o f a certain amount were d i s a l l o w e d a n d some m o r e distant s a w m i l l s apparendy r e c e i v e d less f o r their c h i p s as a result ( C o o p e r 1995). Purchaser G d i d show prices that f e l l a n d that were c o m p a r a b l e to the magnitude o f actual costs; h o w e v e r , these results were significant at the 9 0 % l e v e l . F o r the r e m a i n i n g six firms, prices d i d not v a r y significantly w i t h distance. T h r e e o f the  firms,  E , H , a n d I, saw a significant change i n the influence o f distance o n price i n p e r i o d III, where the p r i c e n o w fell f o r E a n d H w h i l e the p r i c e rose f o r F i r m I.  T h e next set o f coefficients i n T a b l e 1 3 shows h o w the p r i c e p a i d f o r c h i p s w a s influenced b y the price o f l u m b e r . F o r e x a m p l e , a $1 increase i n the price o f a thousand board feet dropped the price p a i d by purchaser A .9 cents per B D U . O n l y one purchaser, I, s h o w e d a significant effect: a $1 increase per thousand board feet o f l u m b e r l e d purchaser I to raise its price b y 3.8 cents per B D U . F o r the m o s t part, other purchasers reported negative but insignificant effects.  142  F i n a l l y , the T i m e variable shows the t i m e trend for c h i p prices, h o l d i n g a l l the other variables constant. F o r e x a m p l e , i n the case o f purchaser A , the p r i c e was i n c r e a s i n g b y 2 7 cents per B D U per m o n t h over the t i m e p e r i o d . T w o o f the ten purchasers, D and F , s h o w e d significant increases w h i l e the rest s h o w e d no significant change.  Quite clearly u n i f o r m s a w m i l l p r i c i n g , or f o r m u l a p r i c i n g based o n a percentage price o f p u l p e x p l a i n s the price o f residual w o o d chips quite w e l l for most o f the purchasers i n the B C Interior. P r i c e s ranged around the percentage used as the m i n i m u m p r i c e b y the government o r i g i n a l l y .  1 1 9  W h i l e most o f the purchasers increased the p r i c e slightly f r o m  the first p e r i o d to the second i n response to government intervention, a l l but one significantly increased the price they p a i d w e l l above previous levels d u r i n g the third p e r i o d ( w h i c h is chosen to cover the p e r i o d d u r i n g w h i c h it is hypothesized p u l p m i l l s reverted to m o r e competitive price-setting behavior).  T h e evidence is somewhat m o r e m i x e d i n terms o f the spatial pattern o f prices. T h e m o d e l predicts that the prices received b y s a w m i l l s f r o m p u l p m i l l s w i l l vary w i t h distance (the net price decreasing i f both purchasers are located together and increasing w i t h distance i f the t w o purchasers are located separately). W h i l e several purchasers d i d s h o w significant changes i n the p r i c e p a i d as a f u n c t i o n o f distance, o n l y t w o purchasers, E and H , s h o w e d prices actually v a r y i n g i n magnitude comparable to actual transportation costs.  I n terms o f  market structure (i.e. prices rising under separate locations and f a l l i n g under c o i n c i d e n t locations), the changes were i n the predicted d i r e c t i o n for s i x o f the n i n e f i r m s ( A , B , C , H , I, and J) (no data was a v a i l a b l e i n this p e r i o d for f i r m G ) . T h e s e m i x e d results m a y reflect the fact that the data available for this estimation covers the first several months o n l y of the hypothesized change i n f i r m behaviour, and that not a l l the price changes are f u l l y captured.  ' T h e original percentage was based short tons, w h i l e p u l p today is sold i n metric tonnes. T o convert from a short ton to a metric tonne, d i v i d e by 1.1.  A n indirect confirmation o f the spatial change i n p r i c i n g practices comes f r o m i n f o r m a t i o n released b y the M i n i s t r y o f Forests, w h i c h reports the average p r i c e o f chips for different points w i t h i n the P r o v i n c e that c o i n c i d e w i t h the l o c a t i o n o f s a w m i l l s . W h i l e the reported prices i n c l u d e both an i m p u t a t i o n for transport costs and the effects o f averaging across a l l m i l l s w i t h i n a region, these prices do p r o v i d e some additional i n f o r m a t i o n o n spatial patterns w h e n prices peaked i n 1995.  Table 14. Reported Average Chip Values by Location in the Northern Interior in 1994 and in 1996 ($/BDU for whitewood) Period 1994 ( P e r i o d II) Difference from Prince George price 1996 ( P e r i o d III) Difference from Prince George price  Prince George $60  McBride  Vanderhoof  West Line East Line  Burns Lake  Houston  Smithers  East Line  East Line  East Line  $55  $55  $55  $54  $57  -  $5  $5  $5  $6  $3  $200  $180  $192  $188  $186  $178  -  $20  $8  $12  $14  $22  (Source: Interior Average Chip Values Effective July 1, 1994 and July 1, 1996, from BCMOF Interior Valuation manual) Table 14 shows reported average c h i p values for two different regions i n the Interior: the W e s t L i n e , the rail l i n e extending west f r o m P r i n c e G e o r g e to P r i n c e R u p e r t w i t h several  .  s a w m i l l s located a l o n g the w a y ; and the East line, the same r a i l l i n e r u n n i n g east through Valemount.  T h e m o d e l predicts that competitive p r i c i n g s h o u l d l e a d to the t w o purchasers  p a y i n g a u n i f o r m d e l i v e r e d price i n P r i n c e G e o r g e , w i t h the price p a i d to s a w m i l l s f a l l i n g the further away they l i e f r o m P r i n c e G e o r g e .  1 2 0  A l t h o u g h these reported values i n c l u d e adjustments for d e l i v e r y points a n d freight costs, the u n d e r l y i n g formulae were not changed d u r i n g the t w o periods, and are based o n prices f r o m the preceding year w i t h a three-month l a g . Therefore, the increase i n the difference between the value o f residual chips i n P r i n c e G e o r g e and o f other chips i n the surrounding  These prices include prices paid b y firms other than the three mills i n Prince George.  144  area between J u l y o f 1994 (based o n average prices f r o m A p r i l , 1993 through A p r i l , 1994) and J u l y 1996 (based o n A p r i l , 1995 through A p r i l , 1996) is due to changes i n the prices p a i d for chips between each o f the different locations. Q u i t e c l e a r l y , price levels f a l l m u c h faster as y o u m o v e a w a y f r o m P r i n c e G e o r g e i n 1996, c o m p a r e d to 1994, w i t h the difference comparable to actual transportation c o s t s .  Market  Power  and Firm  121  Reactions  T h e results presented i n T a b l e s 1 3 a n d 1 4 are strongly suggestive o f a change i n c h i p price determination i n the Interior b e g i n n i n g i n 1994. H o w e v e r , they are restricted b y data limitations and b y the f o r m o f estimation, w h i c h e x a m i n e d h o w changes i n end-product prices affected the prices p a i d b y f i r m s for w o o d c h i p s .  Q u i t e c l e a r l y , another factor i n terms o f the h o w f i r m s set prices i s h o w they w i l l respond to changes i n each others' prices. T h e m o d e l shows a potentially abrupt discontinuity as firms m o v e f r o m a relatively stable p r i c i n g system to a more competitive p r i c i n g scheme, as firms instantaneously s w i t c h p r i c i n g systems and change price l e v e l s .  T h e real w o r l d is more c o m p l i c a t e d . F i r m s (pulp m i l l s ) m a y not i m m e d i a t e l y recognize deviations f r o m existing p r i c i n g systems; alternatively, they m a y resist r a i s i n g prices at first u n t i l the possible risk o f l o s i n g a c h i p supplier becomes c l e a r l y established. Furthermore, the m o d e l suggests that firms c a n costlessly and s m o o t h l y s w i t c h to the o p t i m a l p r i c i n g system under c o m p e t i t i o n . H o w e v e r , transaction costs m a y be significant, and firms m a y not recognize the o p t i m a l system, especially under r a p i d l y c h a n g i n g conditions and imperfect information. F i r m s m a y decide to simultaneously increase a l l their prices without changing the p r i c i n g system; this m a y be even m o r e l i k e l y i f the firms have h a d a l o n g history o f f o l l o w i n g certain p r i c i n g systems.  145  A m o r e plausible f o r m u l a t i o n i s that f i r m s , instead o f instantaneously m o v i n g f r o m one e q u i l i b r i u m to another, effectively enter a transition state where the prices they set w o u l d depend i n part u p o n what they t h i n k others are p a y i n g . I n some sense, f i r m s w o u l d d e v e l o p reaction functions, w h i c h w o u l d dictate h o w they w o u l d respond to another f i r m ' s prices.  There are m a n y m o d e l s w i t h i n game theory that e x a m i n e h o w assumptions about reaction functions c a n change outcomes. It should be stressed that i n these m o d e l s , reaction functions have a functional stable f o r m ; that is, w h i l e prices m a y be c h a n g i n g , the f i r m s ' behaviour remains invariant.  Estimating Response Functions M o d e l s that e m p i r i c a l l y examine f i r m interaction are rare, reflecting the difficulty i n obtaining sufficient f i r m l e v e l data. O n e m o d e l that does is Slade (1986), w h o s p e c i f i c a l l y e x a m i n e d f i r m interaction i n her study o f gasoline p r i c i n g d u r i n g a gasoline w a r i n V a n c o u v e r i n the s u m m e r o f 1985. I n the m o d e l , a f i r m ' s d e m a n d c u r v e i s based o n the prices set b y itself and other f i r m s and o n other exogenous factors. It is then possible to derive the parameters o f the d e m a n d curve and identify the predicted reaction function o f the f i r m s . T h e m o d e l c a n then be used to estimate the f i r m s ' reaction functions—how f i r m s alter their prices i n response to changes i n other firms' prices—and tested against the behavior predicted under certain conjectural assumptions. Slade (1986) c o l l e c t e d prices f r o m both major and independent gasoline stations i n V a n c o u v e r d u r i n g a p r i c e w a r to see h o w closely the actual outcome matched theoretical predictions o f cooperative and n o n cooperative behavior. T h e actual estimation w i t h i n the m o d e l gauged h o w each type o f  It is approximately 200 k m from M c B r i d e to Prince George and 9 8 kilometres from Vanderhoof, suggesting imputed transportation costs o n the order o f 10 cents per B D U per k m i n 1996.  146  f i r m s ' prices change i n response to changes i n the other's prices, and s h o w e d that increased responses were correlated w i t h greater c o m p e t i t i o n .  Examining  Firm  122  Interaction  T h e m o d e l developed i n Chapter 3 does not have e x p l i c i t reaction functions. B u y e r s practice Bertrand p r i c i n g , w h i c h means they anticipate that the r i v a l buyer w i l l pay slightly m o r e i f the f i r m attempts to purchase the g o o d for less than the m a x i m u m the other f i r m i s w i l l i n g to pay ( i n some sense this is a k i n d o f instantaneous ratcheting up o f the p r i c e ) . U n d e r the assumption that f i r m s are u s i n g a U n i f o r m S u p p l i e r p r i c i n g system and that firms use a f i x e d percentage o f the price o f p u l p to coordinate prices, w e s h o u l d then  ,  observe a s w i t c h to prices based o n m a r g i n a l revenue w h e n f i r m s start to behave c o m p e t i t i v e l y . F i r m s do respond to one another's prices o n l y i n the sense that they w i l l m a t c h each other's prices i n the competitive e q u i l i b r i u m . S p e c i f i c a l l y , f i r m s w i l l respond to the other's i n d i v i d u a l m a r g i n a l revenue i n gauging what p r i c e to set, and they m a y use the price p a i d b y the other f i r m as an i n d i c a t i o n o f their m a r g i n a l revenue (as it w o u l d be i n a competitive market).  T h e r e are t w o hypotheses that c a n be tested. T h e first i s an e x p l i c i t prediction o f the m o d e l : i f f i r m s do s w i t c h f r o m f o l l o w i n g some k i n d o f p r i c i n g system to a set o f m o r e c o m p e t i t i v e prices, there s h o u l d be a measurable change between the t w o periods; that i s , a significant difference i n h o w prices e v o l v e d w i t h i n each o f the t w o periods.  T h e second hypothesis is m o r e indirect and l o o k s for h o w i n d i v i d u a l f i r m responses to one another m a y have changed between the t w o time periods. A priori, one w o u l d expect that under a perfect p r i c i n g system a l l f i r m s w o u l d use a f i x e d percentage o f the p u l p price and ignore changes i n one anothers' prices, w h i l e under the assumption o f a c o m p l e t e reversion  122  Slade (1986) notes that her model was limited to e x a m i n i n g the behavior o f gasoline stations o n l y during the price war, as the uniformity o f prices during periods o f price 'peace' meant that there were no significant differences to be examined.  147  to the P r i s o n e r s ' d i l e m m a firms w o u l d i m m e d i a t e l y start p a y i n g the f u l l residual m a r g i n a l v a l u e . T h e truth i s l i k e l y to l i e somewhere i n between the t w o (for e x a m p l e , suppose one f i r m f o l l o w s a p r i c i n g system, and other f i r m s base their prices o n the p r i c e leader); however, one w o u l d expect increased f i r m interaction as f i r m s m o v e towards a more competitive o u t c o m e .  123  G i v e n that the data set covers a p e r i o d o f r a p i d l y  rising  prices, and the assumption that prices w i l l be m o v i n g towards m o r e c o m p e t i t i v e l e v e l s , one w o u l d expect to see a p o s i t i v e increase i n f i r m s ' responses.  T h e estimation procedure used is based o n the V e c t o r A u t o r e g r e s s i v e ( V A R ) m o d e l used i n estimating d y n a m i c simultaneous equations. Judge et a l . (1988) p r o v i d e a n o v e r v i e w o f this approach, w h i c h is used f o r m u l t i p l e time series where there is interaction between the variables. T h e a p p r o a c h i n v o l v e s r u n n i n g simultaneous equations o f different autoregressive processes that m a y i n c l u d e exogenous explanatory variables. T h e advantage o f this approach i s that i t a l l o w s for error terms to be correlated across the equations w h i c h a l l o w s for greater efficiency i n estimation.  Data T h e data set used to estimate i n d i v i d u a l p r i c i n g patterns ended i n J u l y 1994 as access to the database was t e r m i n a t e d .  124  Further research identified a set o f m o n t h l y prices for the f i v e  largest purchasers w i t h i n the Interior f r o m January 1995 through F e b r u a r y 1996, y i e l d i n g an a d d i t i o n a l 100 data points. A s these prices w e r e those reported b y the purchasers f o r a l l their transactions, the i n d i v i d u a l transactions f r o m the previous data set were aggregated to produce w e i g h t e d average purchaser prices to m a k e the t w o sets comparable. T h e total n u m b e r o f months c o v e r e d between D e c e m b e r 1987 and F e b r u a r y 1 9 % w a s 8 0 . H o w e v e r , due to m i s s i n g transactions (either n o i n f o r m a t i o n w a s a v a i l a b l e f o r a specific m o n t h o r  1  T h i s approach is similar to one f o l l o w e d by Slade (1986), w h i c h uses Granger causality to test for price exogeneity as a means o f determining market boundaries.  T h i s appeared to reflect a g r o w i n g uneasiness about l o o m i n g trade actions vis-a-vis the Americans coupled with a change i n how the data was collected.  1  148  there was no i n f o r m a t i o n o n one o f the f i v e purchasers for that month), the f i n a l p e r i o d c o v e r e d was f r o m the b e g i n n i n g o f 1990 through F e b r u a r y , 1996.  O n e p r o b l e m w i t h estimating time-series equations is that the process m a y be n o n stationary due to the presence o f t i m e trends, seasonal patterns, o r t i m e - v a r y i n g variances. T h e p r o b l e m appeared i n the latter part o f the p e r i o d and it was necessary to take first differences to ensure the process was stationary.  Modeling  Firm  Interaction  T h e m o d e l permits t w o specific formulations to be tested, u s i n g either a f i x e d percentage o f the pulp price d u r i n g the p e r i o d o f price coordination, or the residual v a l u e o f the chips d u r i n g the p e r i o d o f competitive behavior, as w a s done i n  Figure  20.  T h e m o d e l forces no restrictions o n what p e r i o d f i r m s observe the price o f p u l p o r the m a r g i n available other than that they do not forecast future prices. H o w e v e r , the differences i n f i r m s observed other f i r m s ' c h i p prices are restricted to periods prior to the current p e r i o d i n w h i c h the f i r m is setting its o w n c h i p price. G i v e n the secrecy w i t h w h i c h c h i p prices tend to be guarded, it is not possible to specify h o w q u i c k l y p u l p f i r m s m a y learn about one anothers' prices. Therefore, a one a n d t w o p e r i o d l a g were e x a m i n e d to see w h i c h p r o v i d e d the best fit. P u l p prices w e r e transformed by t a k i n g 9 % o f the current price so that the magnitude o f the response w a s comparable to other f i r m s ' prices; this d i d not change the overall fit and meant that the coefficient c o u l d be interpreted i n terms o f h o w w e l l the price changes matched changes i n the percentage s e l l i n g price o f p u l p .  A l l o w i n g for f i r m interaction and the p o s s i b i l i t y that f i r m s d i d respond to one another's prices changes leads to equation (4), w h i c h shows the price p a i d by a f i r m as a f u n c t i o n o f changes i n the price o f p u l p and changes i n other f i r m s ' prices:  149  where a>0 a n d b> 1.  A P . - f t x A f t i f c ^ + J ^ A I *j,t-b  (4)  A l l o w i n g for prices to respond to changes i n the m a r g i n a l value product leads to equation (5). In this case, m a r g i n a l v a l u e product is constructed as i n F i g u r e 2 0 b y subtracting $ 4 0 0 f r o m the p r i c e o f p u l p , correcting for the y i e l d (about 4 5 % ) , and deflating to convert current costs into n o m i n a l prices for p r e v i o u s p e r i o d s .  (5)  Results  AP  a  = A x margin  from  Estimating  ,_ + ] > \ / 3 A / > j.t-b a  w  Firm  125  T h e specific equation i s :  where a>0 a n d b> 1.  Interaction  T a b l e s 1 5 and 16 show the results o f the estimation. T h e first c o l u m n shows the f i r m , the second the effect o f Pulp or Margin o n the f i r m ' price, w i t h the subsequent f i v e c o l u m n s the effect o f that particular f i r m s ' price. T-ratios are reported under each variable and coefficients significant at the 9 5 % l e v e l are i n b o l d . T h e R f o l l o w s each equation, and 2  the A k a i k e Information C r i t e r i o n ( A I C ) is also reported for each set o f e q u a t i o n s .  126  In addition, both sample periods were evaluated using the alternative measures Pulp or Margin to see w h i c h p r o v i d e d the better fit w i t h i n each period. It turned out that the previous p e r i o d p u l p ' s p r i c e , as suggested i n T a b l e 1 3 , p r o v i d e d the best fit d u r i n g the p e r i o d o f assumed p r i c e coordination, w h i l e the current m a r g i n p r o v i d e d the best fit d u r i n g the reversionary p e r i o d .  1 2 7  A k a i k e ' s A I C criterion was m i n i m i z e d to determine that a process o f order 1 best fit the available data i n each period.  1 2 5  T h i s was the cost per tonne of producing p u l p i n B C , excluding fibre costs, i n 1994 ( B C M O F 1995). Because the recovery rate is 4 5 % (that is, one tonne o f w o o d chips w i l l y i e l d .45 tonne o f pulp), the marginal value o f w o o d chips is arrived at by deducting the manufacturing cost o f chips f r o m the selling price and then m u l t i p l y i n g by .45.  1 2 6  Strictly speaking, the T-ratios show whether or not Granger causality exists, defined as to whether or not that variables improves the ability to predict the price o f the variable i n question. W i t h a process o f order 1, the test for Granger Causality is the equivalent of a T-test.  1 2 7  Best fit was that set o f equations that m i n i m i z e d the A I C w i t h i n that order. In addition, the R for the individual equations was greater for three o f the five equations, compared to those using pulp. 2  150  Table 15. Price Behavior under Assumed Price Coordination, 1990-February, 1994 (n=51) Firm A  Pulp .14  A  (.27) B  .61  (4.38) C  D  -.16  (1.47)  .68  .63  (2.09) C R I T I C A L  (.38)  (.11)  -.11  (2.10) E  -.06  (.95) (2.47)  .38  (1.09)  .47  D .02  B  .03  -.07  (.54)  (1.21)  .59  -.31  (.88)  (4.01)  R  E -.06  (.34)  1  .03  .19  .30  .13  .26  (2.84) (.76)  -.05  -.25  -.15  .02  (.44)  (.85)  (1.40)  (.15)  .27  (3.63)  V A L U E  C  O F T  .21  -.01  (.70)  (.11)  F O R 9 5 %>  L E V E L  .11  -.21  .16  (1.64) O  FC O N F I D E N C E  ( O N E -  SIDED)=1.94 AIC=  •16.418  In the first period, p u l p prices are significant for f i r m s B , D , and E , and c o m p a r a b l e i n magnitude, w h i l e p u l p prices are positive but insignificant for the other t w o firms. I n terms o f the t i m i n g o f the response, prices p a i d b y other f i r m s for residual c h i p s u s i n g a t w o p e r i o d l a g p r o v i d e d a s l i g h d y better fit than one o r three p e r i o d l a g . There was l i m i t e d f i r m interaction, w i t h B s h o w i n g a negative response to f i r m A ' s price a n d a positive response t o E ' s , w h i l e f i r m E s h o w e d a positive response to f i r m A ' s price. F i r m C also s h o w e d a positive response to changes i n f i r m D ' s p r i c e . F i r m A lies between B a n d E , w h i l e F i r m D i s the closest f i r m t o C , suggesting a geographical reason for some o f the interaction.  T h e second p e r i o d , w h e n o p e n b i d d i n g for chips o c c u r r e d , p r o v i d e s m o r e a m b i g u o u s results. W h i l e f i r m A shows that the available m a r g i n p l a y e d a significant role i n determining its prices, three o f the four f i r m s show the m a r g i n had a p o s i t i v e but insignificant effects w h i l e the fourth, C , shows a negative but i n s i g n i f i c a n t effect. F i r m s B , C , and D show strong a n d significant responses to changes i n F i r m A ' s p r i c e and negative responses to F i r m E . I n a d d i t i o n , F i r m B , shows a negative response t o C s p r i c e .  151  Table 16. Behavior of Prices After Open Bidding Commenced: March, 1994 - February, 1996 (n=16*) Firm A  Margin  A  .43  (3.10) B  .09  (.59) C  -.06  (.59) D  .12  (1.06) E  C .44  D -.22  E .13  (.94)  (1.28)  (.60)  (.65)  -.64  .58  (1.56)  -1.83  .60  (2.12)  .73  2.81  (2.91)  3.34  (7.49)  1.78  (2.79)  R  B -.20  .15  .15  -2.62  (.93)  (6.35)  -.01  .03  (.15)  .18  .32  -.01  (1.05)  (1.22)  (.05)  .33  (.74).  .48  (2.08)  (1.56) (.06)  1  -1.18  .55  (1.97)  -.39  .21  (.85)  "reflects m i s s i n g months C r i t i c a l t for 9 5 % (one-sided)=1.94; A I C = 2 3 . 6 6 3  P r i c e s p a i d b y other f i r m s i n the past p e r i o d n o w p r o v i d e d a s l i g h t l y better fit, suggesting the t i m i n g o f their responses h a d shortened. Interaction between f i r m s increased, both i n the n u m b e r o f inter-firm responses f r o m three i n the first p e r i o d to seven i n this p e r i o d , as w e l l i n the magnitude o f the o v e r a l l responses f o r m o s t f i r m s . S u m m i n g across the response b y each f i r m to each other f i r m ' s price to create a n o v e r a l l reaction, three o f the f i v e , B , C , and D s h o w e d an increase i n their reaction, m o v i n g f r o m the p e r i o d o f assumed price c o o r d i n a t i o n to the reversionary p e r i o d . F o r e x a m p l e , F i r m s B ' s r e a c t i o n i n c r e a s e d f r o m .04 to .92, F i r m C s f r o m .25 to 1.02, a n d F i r m D f r o m -.43 to .62. F i r m E r e m a i n e d r e l a t i v e l y u n c h a n g e d , w i t h .26 i n the first p e r i o d and .25 i n the second, w h i l e F i r m A ' s o v e r a l l reaction d r o p p e d f r o m .37 i n the first p e r i o d to .15 i n the second.  T h i s pattern o f reactions c a n be e x p l a i n e d i n part b y the l o c a t i o n o f the various firms. F i r m E i s located the furthest f r o m the other f o u r firms, w h i l e firms B , C , and D are the closest to each other. F i r m A i s located r e l a t i v e l y equidistant to the other four. T h e i n d i v i d u a l responses suggest that F i r m A was a c t i n g as a p r i c e leader, at least for firms B , C , and D . F i r m E appears to have lagged other firms i n i t i a l l y i n r a i s i n g its prices but then f o l l o w e d F i r m A very c l o s e l y , and this m a y e x p l a i n the apparent negative response b y the other firms to its price changes.  152  T a b l e 1 6 suggests prices d i d not i m m e d i a t e l y and simultaneously m o v e towards a system o f price based o n the m a r g i n a l value o f w o o d c h i p s . W h i l e the m o d e l shows that f i r m s w i l l respond i m m e d i a t e l y b y increasing the price to the m a x i m u m point they are w i l l i n g to pay w h e n coordination fails, the results suggest actual f i r m behavior was m o r e c o m p l e x and that one f i r m became a price leader, w i t h the responses differing a m o n g the i n d i v i d u a l firms. I n part, data limitations restricted the n u m b e r o f firms that c o u l d be i n c l u d e d i n the sample (although the five firms i n c l u d e d are the largest purchasers w i t h i n the Interior) and the t i m e p e r i o d that c o u l d be used i n the estimation. G i v e n the l o n g history o f f o l l o w i n g a specific p r i c i n g system (e.g. f o r m u l a p r i c i n g based o n a percentage o f the output price), it is not surprising that it m a y take t i m e for firms to adjust their expectations about h o w other firms w i l l a c t .  128  It s h o u l d be noted that the m o d e l  d e v e l o p e d does a l l o w for price leadership w h i c h i n turn, depending o n the firm configuration, m a y lead to a B a s i n g P o i n t system. R e c a l l that the m o d e l s h o w e d that firms do not want to practice price leadership, but w o u l d rather instead f o l l o w a price leader. It m a y be the case that p r i c e leadership i n this case m a y reflect a transitory stage between the U S p r i c i n g system and discriminatory pricing.  T h e results do show that there was a change i n the p r i c i n g process consistent w i t h those expected under increased c o m p e t i t i v e behavior. W h y d i d firm behaviour change? R e c a l l that the discount rate c a n reflect firms expectations as to h o w l o n g a particular game to last (or i n another sense h o w l o n g firms w i l l behave a c c o r d i n g to the same rules). T h e fact that a s a w m i l l (and perhaps most importantly the largest s a w m i l l c o m p a n y i n the Interior) was w i l l i n g to put its chips up for b i d , c o u p l e d w i t h a w i l l i n g n e s s b y at least some purchasers to respond, appears to have l e d to p u l p m i l l s r a p i d l y r e v i s i n g their beliefs i n the stability o f both f o r m u l a p r i c i n g and the fixed nature o f their historic market areas. T h e d y n a m i c s o f the prisoners' d i l e m m a asserted themselves w i t h a vengeance, as purchasers r e a l i z e d that c o n t i n u i n g to f o l l o w the o l d system meant that they w o u l d  128  In an interview with George E d g s o n , then vice-president with Slocan, the company that first offered its chips up for b i d i n the Interior, he noted that the initial bids by companies varied quite w i d e l y and that one company submitted a b i d that basically reflected past practices. E v e n after g i v i n g the company another chance to resubmit its b i d , they left the b i d unaltered. T h e o n l y explanation E d g s o n could offer was that they felt that no other company w o u l d try to purchase chips from that sawmill. 153  l i k e l y lose a significant p o r t i o n o f their supply. T h e end result was a m o v e a w a y f r o m c h i p prices based o n a l o w percentage o f the p u l p price towards prices based o n the m a r g i n a l value o f w o o d chips, a l o n g w i t h increased f i r m interaction as p u l p m i l l s actually c o m p e t e d for suppliers.  Summary In s u m m a r y , the significant increase i n price levels o f p u l p chips starting i n 1994 i s associated w i t h a change i n market p o w e r due to a change i n f i r m behavior. W h i l e it appears somewhat p u z z l i n g h o w such a change c a n have such an abrupt i m p a c t i n terms o f such r a p i d increase i n price l e v e l s , as seen i n Figures 21 and 22, such an increase i s consistent w h e n the participants find themselves i n a prisoners' d i l e m m a . T h e participants m o v e f r o m a beneficially j o i n t outcome to a less desirable outcome (and r e m a i n there) so l o n g as each firm anticipates the other firms w i l l n o longer adhere to a particular set o f rules. I n this case, the f i r m s ' ability to coordinate prices a m o n g themselves d i m i n i s h e d sharply as they m o v e d a w a y f r o m f o r m u l a p r i c i n g , a n d the result was a significant increase i n the overall price l e v e l .  T r a d i t i o n a l explanations o f market p o w e r i n this context w o u l d have m i s s e d m u c h o f the explanation f o r the change i n prices. N e i t h e r market structure n o r market concentration, the classical determinants o f market power, changed o v e r the study p e r i o d . U t i l i z a t i o n rates, w h i l e p e a k i n g i n the s u m m e r o f 1995, post-dated the change i n behaviour o f some c h i p sellers, and w o u l d be m i s l e a d i n g i f used as the sole criterion. W h i l e the relative d e m a n d and supply o f chips i n f l u e n c e d the degree o f the p r i c e m o v e to some extent, it was ultimately a change i n firm behaviour most responsible for the dramatic change i n prices. H i s t o r i c supply relationships that had existed unchanged since the i n t r o d u c t i o n o f c h i p direction twenty years earlier d i s s o l v e d as s a w m i l l s put their c h i p s up f o r a u c t i o n and p u l p m i l l s b i d against each other.  1  P u l p m i l l s w i t h i n the area, b y virtue o f their size and l o c a t i o n , d o enjoy inherent structural market power, m u c h as an isolated s a w m i l l w i l l enjoy market p o w e r i n its l o c a l l o g markets. H o w e v e r , government p o l i c y d u r i n g the i n i t i a l development o f this market h e l p e d to reinforce the p u l p m i l l s ' market p o w e r . F o r e x a m p l e , c h i p d i r e c t i o n p r o v i d e d a w a y for f i r m s to organize their suppliers without h a v i n g to compete for t h e m .  1 2 9  Chapter 1  showed that m a n y o f the p u l p companies felt that the m a i n p r o b l e m associated w i t h the proposed P A ' s i n the 1 9 8 0 ' s and 1990's was the i n t r o d u c t i o n o f uncertainty as a result o f the loss o f directed chips and a potential re-ordering o f supply relationships. R e s t r i c t i o n s on the export o f chips also reduced potential c o m p e t i t i o n f r o m purchasers outside the region, a l o n g w i t h the uncertainty associated w i t h the potential for market e n t r a n t s .  130  In  addition, the cooperative nature o f F i b r e c o E x p o r t , through its average cost p r i c i n g , also lessened the potential for c o m p e t i t i v e pressures f r o m the export market. F i n a l l y , e v e n w h e n the c h i p d i r e c t i o n p o l i c y was dropped, purchasers retained the right o f first refusal, w h i c h was the right to meet any other potential purchaser's offer for chips w i t h i n their area. T h i s appeared to w o r k m u c h l i k e clauses a m o n g retailers guaranteeing that they w i l l m a t c h or beat the l o w e s t advertised price; under such c o n d i t i o n s , f i r m s are u n w i l l i n g to l o w e r prices to attract additional customers because any p r i c e cuts w i l l be matched, r e d u c i n g the l i k e l i h o o d o f any increase i n market share. C h i p d i r e c t i o n helped define where p u l p m i l l s r e c e i v e d their s u p p l y ; once that c o n c e r n was sorted out, purchasers c o u l d focus o n the issue o f w h a t prices to pay.  T h e introduction o f m i n i m u m p r i c i n g p r o v i d e d a n e x p l i c i t s i g n a l i n g d e v i c e .  1 3 1  Burns  (1936, p. 84) provides an analogy i n the introduction o f m i n i m u m p r i c i n g for steel i n the U S i n the 1930s and h o w it l e d to price u n i f o r m i t y a m o n g the major steel producers.  129  " A l b e r t a also introduced ' c h i p d i r e c t i o n ' i n the 1970's w h i c h still exists today. Sundance (a sawmill i n Edson) has asked the provincial government to axe chip direction, w h i c h severely depresses c h i p prices." K o c h , 1995  130  Other potential purchasers include pulp and paper m i l l s on the B C Coast. T h e key for them is transport costs for Interior chips and the cost o f alternative supplies.  131  In the technical language o f game theory, this provides a focal point w h i c h enables participants to choose among a variety o f potential equilibria.  155  M i n i m u m c h i p p r i c i n g d i d m u c h the same i n the Interior b y p r o v i d i n g a structure (a percentage o f the p u l p price) that reduced the computational uncertainty i n t r y i n g to figure out what other buyers were p a y i n g . A s Scherer (1980) pointed out, i d e n t i f y i n g prices at the purchase point removes some o f the uncertainty relative to reporting prices delivered at the m i l l , where changes i n prices c o u l d either reflect changes i n transportation costs or changes i n the purchase p r i c e .  1 3 2  T h e C O F I C h i p A u d i t report, w h i c h shows the c o n s u m p t i o n and p r o d u c t i o n o f p u l p fibre i n the northern Interior o n a quarterly basis and circulates w i t h i n the p u l p and paper industry. It p r o v i d e s a means for firms to m o n i t o r one another's actions. B y i d e n t i f y i n g suppliers and i n v e n t o r y l e v e l s , it further reduces the uncertainty surrounding the s u p p l y o f chips i n a large part o f the Interior and helps facilitate price coordination (recall the quote f r o m P h l i p s (1981) i n C h a p t e r 2). T h e presence o f such a report, a l o n g w i t h the reliance o n the percentage set b y the government i n i t i a l l y , suggest that these i n f o r m a t i o n requirements are quite important i n leading to these types o f tacitly c o l l u s i v e outcomes. M o r e generally, see H o w a r d and Stanbury ( 1 9 9 0 ) .  A l o n g the same lines, it is interesting to note that under conditions o f o l i g o p s o n y , firms appear to prefer setting prices at the s u p p l i e r ' s l o c a t i o n as opposed to the purchaser. F o r e x a m p l e , the Federal T r a d e C o m m i s s i o n i n 1934 issued an order r e q u i r i n g that large m i l l s purchasing cottonseed to stop p u b l i s h i n g b i d prices w h i c h were calculated at the s h i p p i n g points, as it was felt that such a practice l e d to non-competitive p r i c e s .  133  A report issued  b y a C o n g r e s s i o n a l committee i n 1939 also noted that i n the scrap metal industry, where  132  133  T h i s point is made by P h l i p s regarding the introduction o f the multiple basing point p r i c i n g system i n Europe for steel, where he states that " T h e basic ingredient o f tacit c o l l u s i o n is perfect information on actual prices, here delivered prices. Tacit collusion is therefore much easier with basing point prices than with f.o.b. m i l l prices. W i t h the latter, there is uncertainty as to the exact delivered price...buyers may exploit this to obtain secret price reductions and then may carry out arbitrage through resale, so that general price levels may fall through the weakening o f the geographical structure o f delivered prices." Note that is for firms selling as opposed to purchasing goods, but the basic principle o f removing potential uncertainty remains the same. Phlips, (1983: 306-307). Temporary N a t i o n a l E c o n o m i c Committee (1939: 293).  156  there were very f e w buyers relative to a large n u m b e r o f s m a l l sellers, prices were quoted F O B s h i p p i n g p o i n t .  1 3 4  A l o n g the same lines, a R o y a l C o m m i s s i o n investigated p u l p w o o d purchasing practices i n Eastern C a n a d a i n 1958 after allegations o f c o l l u s i o n i n terms o f b i d d i n g .  A m o n g the various m e m o s and  discussions between the various p u l p companies p r o v i d e d to the C o m m i s s i o n regarding their purchasing practices, is one where a participant notes that purchases: " s h o u l d be F O B [raillcar and that F O B m i l l p r i c i n g was a dangerous p r a c t i c e . "  135  P r i c e s here were for the most part determined  at the s u p p l i e r ' s s h i p p i n g point. L o f g r e n ' s (1985) observation that the practice o f setting u n i f o r m roadside prices i n S w e d e n for p u l p w o o d reflects c o n c a v e supply curves m a y be i n c o m p l e t e ; this method o f quoting prices also has the strategic effect o f e n a b l i n g firms to m o r e easily coordinate prices and thereby l i m i t competitive b e h a v i o u r . T h i s also suggests that D u e r r ' s (1994) observation about the i n t r o d u c t i o n o f l o c a l p r i c i n g i n the U . S . S o u t h for p u l p w o o d m a y be b a c k w a r d s ; that is, l o c a l p r i c i n g was introduced to hinder the emergence o f m o r e competitive b e h a v i o u r and d i d not reflect increased competition. T h e widespread c o i n c i d e n c e o f roadside or s a w m i l l p r i c i n g w i t h i n p u l p w o o d markets around the w o r l d l i k e l y reflects participants' awareness that this m e t h o d o f quoting prices, m a y avert or at least d u l l c o m p e t i t i v e behavior.  A s s h o w n b y the m o d e l , the dramatic increase i n prices suggests that once tested, this particular price e q u i l i b r i u m was not very stable as p u l p m i l l s engaged i n competitive b e h a v i o r as c h i p s were put up for b i d . I n the m o d e l , the discount rate i s exogenous, and e v e n a slight change i n the discount rate c a n be sufficient to lead firms to m o v e f r o m one outcome to another. W h i l e it i s not possible to w e i g h t h o w m u c h firms' evaluation o f future benefits and costs changed, it seems u n l i k e l y that either reaction periods (that i s , the amount o f time it w o u l d take f i r m s to respond to one another's price changes) or interest rates changed significantly. T h e most plausible explanation for the change i n the discount factor is l i k e l y due to firms' c h a n g i n g b e l i e f about h o w l i k e l y the previous system o f fixed  134  Ibid. (p. 341).  157  market areas and f o r m u l a p r i c i n g w o u l d last. I n d i v i d u a l f i r m s ' perceptions o f h o w circumstances h a d changed appeared to vary quite substantially at first. G e o r g e E d g s o n , o f S l o c a n , said that c o m p a n i e s submitted w i d e l y v a r y i n g bids w i t h one c o m p a n y resubmitting the same price schedule that it was currently using ( E d g s o n , 1995). H o w e v e r , o n c e suppliers started to s w i t c h , purchasers appeared to feel that they c o u l d lose any p o r t i o n o f their c h i p supplies i f they d i d not m a t c h the price changes, and as one fibre s u p p l y manager noted: "every time some chips j u m p e d f r o m p u l p m i l l A to p u l p m i l l B , the price went up b y another $ 10 per B D U " .  1 3 6  W h i l e some firms i n i t i a l l y signed contracts l i n k i n g c h i p  prices to the p r i c e o f p u l p at higher percentages than previous contracts, prices soon started to exceed these ' f o r m u l a ' prices. T h e s e ' b o n u s e s ' q u i c k l y v a n i s h e d w h e n p u l p prices started to d e c l i n e .  137  T h e c i r c u l a t i o n o f i n f o r m a t i o n o n c h i p production and c o n s u m p t i o n w i t h i n part o f the r e g i o n suggests that p u l p m i l l s are w e l l aware o f the potential c o m p e t i t i o n f o r suppliers and b e l i e v e they must m o n i t o r one another's actions. T h i s suggests that the i n f o r m a t i o n requirements to sustain these types o f non-competitive outcomes are quite important and it is not clear to what extent i n f o r m a t i o n o n both prices and quantities are needed. It does suggest that h o w prices e v o l v e o v e r future periods w i l l be strongly i n f l u e n c e d b y h o w purchasers perceive the security o f their l o c a l market areas and h o w they respond to one another's actions. T o the extent that p u l p markets soften and d e m a n d lessens, firms m a y feel that the potential c o m p e t i t i o n has lessened, decreasing the perceived elasticity, and the p r i c e w i l l drop. I f n e w purchasers enter an area, disrupting supply patterns, prices m a y rise. It is u n l i k e l y prices w i l l continue to r e m a i n a constant fixed percentage o f the p u l p price i f firms continue to w o r r y about securing their fibre supplies.  ' Restrictive Trade Practices C o m m i s s i o n (1958): 62. ' T h e manager wished to remain unidentified but represented a large consumer o f p u l p fibre i n the Interior. ' T h i s fact emerged i n a series o f interviews with sawmillers throughout the region.  158  F o r m u l a p r i c i n g i s s i m p l y another type o f d e l i v e r e d p r i c i n g system where i n this case prices are set u n i f o r m l y across a l l suppliers regardless o f l o c a t i o n . T h i s type o f p r i c i n g offers several advantages to purchasers that practice it. First, b y u s i n g a percentage o f the p u l p price to set the same price to a l l its suppliers and p a y i n g f o r a l l the transportation costs, the p u l p m i l l ensures that it captures any l o c a t i o n a l rents and a l l o w s it to selectively purchase f r o m its suppliers i f it chooses to d o so. F o r e x a m p l e , i f the p u l p m i l l wanted to increase its purchases o f w o o d chips, i t c o u l d purchase c h i p s f r o m m o r e distant s a w m i l l s that it currently d i d n ' t b u y f r o m w i t h o u t h a v i n g to raise the p r i c e across a l l o f its suppliers (where the net price r e c e i v e d the s a w m i l l is the same but the chips are more costly due to the increased transportation c o s t s ) .  138  S e c o n d , this m e t h o d o f price-setting enables f i r m s to  coordinate prices and m o n i t o r one another m u c h m o r e easily b y significantly r e d u c i n g the computational uncertainty i n determining prices. U n d e r f o r m u l a p r i c i n g , a purchaser c a n assume that i f they learn the price p a i d b y a r i v a l purchaser to any one supplier that the price w i l l be representative o f a l l the other r i v a l ' s suppliers. Purchasers d o n ' t have to w o r r y about changes i n transportation costs, w h i c h are a significant part o f the d e l i v e r e d cost o f fibre, a n d w o u l d l i k e l y affect the o v e r a l l price l e v e l under another type o f p r i c i n g scheme. T h i s also reduces some o f the uncertainty i n price setting.  T h i s type o f p r i c i n g also has the benefit o f r e d u c i n g any i n c e n t i v e for s a w m i l l s (or a third party) to try a n d arbitrage to take advantage o f the difference i n d e l i v e r e d costs. A s each s a w m i l l receives the same price for its chips, and since p u l p m i l l s take care o f a l l transportation, n o s a w m i l l o r other party perceives any benefit f r o m t r y i n g to b u y and resell chips since a l l c h i p s are price the same. F i n a l l y , this type o f p r i c i n g has a superficial appeal i n that equal prices seem " f a i r " to at least some o f the s a w m i l l s u p p l y i n g c h i p s .  !  1 3 9  T h i s is o n l y true to the extent there may be sawmills w i t h uncommitted chips.  ' Opinions among sawmillers are divided but a surprising number felt this way. A s one sawmill operator told me, " i f we're [their sawmill] getting the short end o f the stick [through a l o w price], then at least everybody else is as well [referring to other sawmills s u p p l y i n g the pulp m i l l ] . "  159  In terms o f e c o n o m i c theory, these results suggest that e x p l i c i t d e l i v e r e d p r i c i n g systems do facilitate less competitive outcomes through m a k i n g price c o o r d i n a t i o n easier. Furthermore, as suggested b y the magnitude o f the p r i c e change, s u c h systems c a n l e a d to outcomes that take o n the characteristics o f a prisoners' d i l e m m a . T h e p r i c i n g system m a y not be e x p l i c i t l y (overtly) organized to facilitate c o l l u s i o n (or as i n the case o f the Interior market reflect the unanticipated effect o f p o l i c y choices). B y reducing uncertainty and p r o v i d i n g a m e c h a n i s m b y w h i c h f i r m s c a n establish c o m m o n prices, h o w e v e r , f i r m s m a y n o w be able to reach tacitly c o l l u s i v e outcomes. C o n t r a r y to the results i n E s p i n o s a (1992), the m o r e general e c o n o m i c m o d e l d e v e l o p e d i n this thesis, supported b y an examination o f actual market behaviour, suggests that u n i f o r m prices d o not necessarily reflect the competitive outcome. Instead, these types o f p r i c i n g patterns s h o u l d be v i e w e d w i t h s k e p t i c i s m and e x a m i n e d to see to what extent they m a y permit price coordination.  160  5. The Policy Implications of Market Power  "You have to wonder if the price [of chips J can ever go as high again or the premiums paid over the formula prices can ever be realized again," says analyst Hamish Kerr.. .1 don't think you need to go to $220per bdu to get enough wood." as quoted in the Logging & Sawmilling Journal, June 1996  A s noted i n Chapter 1, the B C Interior market differs quite substantially f r o m other p u l p fibre markets i n N o r t h A m e r i c a by the degree to w h i c h residual chips m a k e u p most o f the furnish. T h e inelastic nature o f c h i p supply, c o u p l e d w i t h the j o i n t nature o f c h i p and l u m b e r manufacturing, means it is difficult to identify the costs o f c h i p p r o d u c t i o n . Together, these factors have h a d the effect o f m a k i n g p u l p fibre p r o d u c t i o n i n the Interior relatively insensitive to prices. I n addition, the market for p u l p chips is h i g h l y concentrated o n the d e m a n d side and m u c h less so the seller side. T h r o u g h o u t m u c h o f the Interior, there has h i s t o r i c a l l y been o n l y one or t w o c h i p purchasers for m o s t s a w m i l l s .  Furthermore, the fact that the p r o v i n c i a l government o w n s most o f the forest l a n d w i t h i n the p r o v i n c e gives it a great deal o f control o v e r the industry. F o r e x a m p l e , cutting rights cannot be transferred between companies nor c a n e x i s t i n g facilities be shut d o w n without government a p p r o v a l . B e c a u s e the government regulates so m a n y aspects o f the industry, e v e n relatively " m i n o r " p o l i c y changes c a n have widespread effects.  In the w o o d c h i p market, p r o v i n c i a l government p o l i c y designed to protect both parties ended up creating a particularly stable p r i c i n g structure that persisted past the official discontinuation o f any e x p l i c i t p o l i c i e s regarding c h i p p r i c i n g or production. G i v e n the structural characteristics o f the market, such as an inelastic c h i p supply function a n d a very l i m i t e d n u m b e r o f buyers, this l e d to an u n u s u a l l y r i g i d market where neither prices n o r quantities fluctuated a great deal until the past t w o years. In fact, the analysis i n C h a p t e r 4 shows that m u c h o f the recent change i n prices reflected changes i n f i r m s ' b e h a v i o u r and expectations rather than changes i n d e m a n d or supply conditions.  W h i l e these structural characteristics continue to influence the Interior market, there are also several trends both inside and outside the p r o v i n c e that w i l l also affect the market. I n some cases, they m a y affect the supply and o r d e m a n d for c h i p s d i r e c t l y , w h i l e i n other cases, they indirectly affect the market through their effect o n l u m b e r manufacturing. T h e f o l l o w i n g sections outline these trends and their potential effect o n the Interior market. T h e p r i m a r y issue, at least for the Interior, is not necessarily the p h y s i c a l a v a i l a b i l i t y o f s u p p l y but rather the costs o f that supply.  Global  Trends  in Demand  for Pulp  Fibre  A c o m m o n denominator throughout N o r t h A m e r i c a has been the increasing use o f s a w m i l l residuals by p u l p a n d paper companies as the e c o n o m i c s o f u s i n g these residuals (as a l o w e r cost source o f fibre relative to p u l p w o o d ) have proven increasingly attractive to p u l p mills.  1 4 0  A s a result, most s a w m i l l s n o w find their sales o f residual chips an integral part  o f their cash f l o w , and w o u l d be unable to operate i f they c o u l d not sell their chips. H o w e v e r , the use o f residuals has peaked, a n d analysts expect r o u n d w o o d c h i p p i n g to become increasingly important i n B C w h i l e s a w l o g costs w i l l continue to increase as firms m o v e into m o r e m a r g i n a l timber stands ( A n o n y m o u s 1995).  A t the same t i m e , both p u l p and l u m b e r markets have become noticeably m o r e v o l a t i l e i n recent y e a r s .  141  W h i l e n o definitive analysis has been offered as to the source o f the  v o l a t i l i t y , some possible explanatory variables i n c l u d e the g r o w i n g integration o f the w o r l d e c o n o m y , w h i c h turns l o c a l markets into g l o b a l markets, and fibre shortages i n traditional timber-processing areas s u c h as the P a c i f i c N o r t h w e s t d u r i n g peak market c o n d i t i o n s .  142  ' T h i s trend has been most marked i n Quebec, w h i c h has seen lumber shipments soar as p u l p mills have both bought and built sawmills to take advantage o f the economics o f extracting as m u c h lumber as possible out o f what was previously considered p u l p w o o d . Pulp and Paper Wood Report, October 1995, M i l l e r Freeman. 141  142  See, for example, C o c k r a m (1995) and Songehen and Haynes (1994). It may be the case that initially the entrance o f other firms f r o m outside the local market may have dramatic effects on prices depending on the market structure as local firms may f i n d regular  162  These l o c a l i z e d fibre shortages i n d u c e price rises (where l o c a l i z e d m a y m e a n as large an area as the W e s t C o a s t o f N o r t h A m e r i c a ) , w h i c h i n turn m a k e s other markets m o r e attractive as increased prices c o v e r the transportation costs o f purchasing f r o m m o r e distant markets. A s exchange rates and l o c a l e c o n o m i c c o n d i t i o n s fluctuate, so too does the relative attractiveness o f these markets, and changes i n d e m a n d f r o m outside the traditional market area can l e a d to sharp swings i n p r i c e s .  1 4 3  H a g l e r ( 1 9 % ) has suggested that s m a l l  changes i n d e m a n d f o r w o o d p u l p c a n l e a d to large changes i n price due to the emergence o f a two-tiered g l o b a l supply curve, reflecting the h i g h cost producers i n N o r t h A m e r i c a and S c a n d i n a v i a and the emergence o f l o w cost producers i n A s i a a n d elsewhere. I n s o m e cases, uncertainty about future fibre supply have o n l y added to the v o l a t i l i t y o f markets.  A n o t h e r explanation that has been offered as a n explanation for increased volatility i n the industry has b e e n changes i n the structure o f the industry. Increasing substitution between h a r d w o o d and s o f t w o o d pulps a n d the g r o w i n g n u m b e r o f f i r m s that c a n divert p u l p f r o m their o w n paper m i l l s into the market p u l p trade have added to short t e r m uncertainty, although these factors m a y moderate price changes i n the future. A n i n c r e a s i n g l y c o m p l e x distribution network also makes i t m o r e difficult to evaluate the d e m a n d and supply c o n d i t i o n s for p u l p . I n some instances, inventories m a y be h e l d i n five different places, and the lead-time for f i r m s to ship p u l p f r o m B C to E u r o p e c a n be f r o m 3 0 to 4 5 days (Geist, 1 9 % ) . A s a consequence, w h e n f i r m s p e r c e i v e a potential m a r k e t shortage, they simultaneously increase their inventories a n d prices q u i c k l y rise, creating a self-sustaining p r o p h e c y . T h i s m e c h a n i s m also w o r k s i n reverse. A s perceptions change, f i r m s l i q u i d a t e inventories and prices f a l l . T h e r e i s some suggestion that e v e n moderate adjustments o f  demand/supply patterns disrupted. Over the longer term, as markets become more globalized, the increasing number o f firms and consumers participating may act as a check against sudden changes i n prices due to local market conditions (e.g. increased imports o f orange j u i c e from B r a z i l when frosts reduce harvests i n Florida). ' In a paper presented at a conference i n Atlanta i n M a y o f 1996, the consulting f i r m Jaakko P o y r y suggest that b i g swings i n the price o f export logs from N e w Zealand i n recent years can be attributed to the participation o f the Japanese b u y i n g logs i n the export market. (Jaakko P o y r y , 1996)  163  inventories c a n l e a d to major swings i n p u l p shipments as this aggregate b e h a v i o u r accentuates rather m i n o r changes i n demand ( G e i s t , 1 9 9 6 ) .  A n o t h e r long-term g l o b a l trend is that o f increased cost o f fibre supplies, not o n l y i n C a n a d a , but w o r l d - w i d e . M c L a r e n (1996) reflects the t h i n k i n g o f a number o f analysts w h o believe there w i l l be a p h y s i c a l scarcity o f fibre as d e m a n d for w o o d and paper products outstrips the s u p p l y o f w o o d f i b r e . H a g l e r (1996) argues that there is a regulatory scarcity o f fibre as p o l i c y - m a k e r s have reduced harvest levels to accommodate environmental c o n c e r n s .  1 4 4  T h e net effect, regardless o f the reasons i n v o l v e d , i s to reduce  the v o l u m e o f fibre available and to m a k e the r e m a i n i n g v o l u m e higher cost. S o n g e h e n and H a y n e s (1994) noted that real prices for stumpage i n the P a c i f i c N o r t h w e s t have s h o w n a steady increase since the early 1900s; they also noted that the margins between l u m b e r and stumpage i n the r e g i o n have steadily shrunk over time. It m a y be the case that a s i m i l a r trend i s u n d e r w a y for p u l p f i b r e .  Provincial  Forest  Policy  Initiatives  M a n y o f the same trends described above are also evident i n B C . In response to both environmental concerns and a mandate to pursue sustainable l e v e l s o f harvest, the government has undertaken a series o f p o l i c y initiatives that can generally be grouped under constraints o n harvesting. These i n c l u d e initiatives that w i l l l e a d to a direct reduction i n what is c a l l e d the "conventional cut" w h i c h w i l l p h y s i c a l l y reduce the amount o f w o o d a v a i l a b l e f r o m C r o w n forest lands, as w e l l as r a i s i n g harvesting costs b y directly mandating certain operational procedures.  T h e first set o f p o l i c y initiatives can, generally, be grouped as environmental and l a n d use initiatives. T h e government created the C o m m i s s i o n o n Resources and the E n v i r o n m e n t  144  G i v e n current supply and demand trends, a recent report issued by the International Institute for Environment and Development states that the w o r l d w i l l need an 8 5 % increase i n the production o f  164  ( C O R E ) i n 1992, a p r o v i n c i a l b o d y charged w i t h d e v e l o p i n g and i m p l e m e n t i n g a regional l a n d use p l a n n i n g p r o c e s s .  145  T h e p r o v i n c e also announced the Protected A r e a s  Strategy ( P A S ) i n 1992, p l e d g i n g to increase the amount o f parks w i t h i n B C to 1 2 % o f the p r o v i n c i a l l a n d area b y the year 2 0 0 0 (by m i d 1999 B C had hit a p p r o x i m a t e l y 11.2%). In addition, the p r o v i n c e has developed specific l a n d use plans for areas such as C l a y o q u o t S o u n d i n response to p o l i t i c a l pressure. T h e l a n d use initiatives c a n generally be thought o f as an attempt to identify w h i c h areas are considered suitable for t i m b e r harvesting and w h i c h areas w i l l be managed for other priorities.  I n 1993 the p r o v i n c e also introduced the Forest Practices C o d e ( F P C ) i n response to e n v i r o n m e n t a l concerns about harvesting methods ( P r o v i n c e o f B r i t i s h C o l u m b i a , 1994). T h e C o d e i s directly concerned w i t h harvesting practices and prescribes i n a very detailed manner h o w harvesting c a n be carried out.  T h e p r o v i n c i a l government has also undertaken a series o f initiatives that c a n be grouped as forest management initiatives. T h e most prominent o f these i s the T i m b e r S u p p l y R e v i e w ( T S R ) . T h e T S R i s b e i n g undertaken i n anticipation o f the f a l l d o w n i n harvest rates as the forest industry m o v e s f r o m the existing mature forest w i t h higher v o l u m e s per hectare into second g r o w t h forests that are harvested at a younger age. T o reduce the i m p a c t o f the reductions i n harvest rates o n what is c a l l e d the conventional A A C (softwood s a w l o g s ) , the government is attempting to increase the harvest i n what it calls non-conventional types through the partitioning o f cutting rights. T h e n o n c o n v e n t i o n a l partition consists o f deciduous species, s m a l l e r w o o d than traditionally has been harvested i n the past, and w o o d that i n the past was considered inaccessible o r too costly to harvest. T h e p r o v i n c i a l government completed the first timber supply r e v i e w i n 1997 (termed T S R 1) w i t h a n e g l i g i b l e reduction i n the p r o v i n c i a l A A C o f 1/2 a percent. T h i s , however, was due to  p u l p w o o d over the next 50 years and that there w i l l be continued upward pressure on p u l p w o o d prices. Pulp and Paper Week, A u g u s t 12, 1996, page 5. 145  C O R E recommended land use plans for V a n c o u v e r Island, the C a r i b o o - C h i l c o t i n , and the West and East Kootenays. T h e government incorporated these suggestions i n developing land use plans for the area. T h e C o m m i s s i o n is currently quiescent and there are no signs o f the government r e v i v i n g it.  165  the increase i n the non-traditional harvest types (the conventional softwood A A C decreased f r o m 6 6 . 8 m i l l i o n c u b i c metres to 6 3 . 4 m i l l i o n c u b i c metres or b y 5 . 2 % ) ( T i m b e r S u p p l y B r a n c h , 1999). It is anticipated that the o n g o i n g r e v i e w ( T S R 2) w i l l l e a d to a greater reduction i n the A A C as the f u l l i m p a c t o f increased environmental regulations and set-asides are felt.  T h e p r o v i n c i a l government also increased stumpage rates i n M a y o f 1 9 9 4 .  146  T h e higher  rates were designed, i n part, to fend o f f potential trade a c t i o n b y U . S . l u m b e r c o m p a n i e s , as w e l l as to fund a set o f p o l i c y initiatives that c a n generally be classified as transition/mitigation (Price W a t e r h o u s e , 1995). T h e s e i n c l u d e the Forest R e n e w a l P l a n , the Forest Sector Strategy, and the Forest Jobs C o m m i s s i o n . T h e s e are meant to p r o v i d e assistance to w o r k e r s f r o m j o b losses resulting f r o m l a n d use decisions and to d e v e l o p a strategy for the B C forest sector.  Impacts  of Forest  Policy  Initiatives  T h e m a i n effect to date has been both a reduction i n the amount o f fibre harvested per hectare, as w e l l as an increase i n the cost o f the available fibre (above and b e y o n d that attributable to the l o w e r y i e l d per hectare). A report c o m m i s s i o n e d b y the p r o v i n c i a l government s h o w e d that the cost o f d e l i v e r e d l o g s i n the Interior rose b y $32.46 between 1992 and 1996, w h i l e the cost o f l o g s o n the B C C o a s t rose b y $ 4 6 . 3 5 ( K P M G 1997).  T h e increased cost stems both f r o m the increase i n stumpage rates as w e l l as f r o m s u c h items as increased r o a d construction costs, due to m o r e stringent d e s i g n requirements, increased r o a d i n g as a consequence o f different harvesting practices, and e n v i r o n m e n t a l regulations that n o w require operations to take place i n m o r e inaccessible a r e a s .  147  Increased costs also arise f r o m the increased p l a n n i n g requirements and need for detailed  1 4 6  These rates were reduced i n June o f 1998 and have been contested under the C a n a d a - U S Softwood L u m b e r Agreement ( S L A ) . A settlement was reached i n September 1999 that left rates unchanged but imposed higher export fees for B C under the S L A .  166  harvesting plans. F i r m s also lose  flexibility  i n s c h e d u l i n g their harvest, as p l a n n i n g  requirements require the licensee to have d r a w n up a detailed cutting p l a n at least t w o years i n advance. F i r m s n o w f i n d that i f changes i n market prices have changed the desirability o f their operational p l a n (for e x a m p l e , d u r i n g times o f h i g h p u l p w o o d prices, f i r m s m a y choose to undertake t h i n n i n g or harvest m o r e m a r g i n a l stands than they otherwise w o u l d ) , they are l i m i t e d b y the need to obtain regulatory a p p r o v a l .  148  F i n a l l y , the licensee becomes  m u c h more constrained i n what they cut o n the site and m a y be unable to adjust their harvest profile to market conditions ( i n other w o r d s , b r i n g i n g i n a d d i t i o n a l l o w e r grade material or l e a v i n g m o r e b e h i n d depending o n p r i c e s ) .  149  T h e net effect o f a l l these initiatives w i l l be to reduce the area available for timber harvesting thereby r e d u c i n g the amount o f sawlogs, w h i c h i n turn w i l l decrease the amount o f residual chips available. T h e net effect o f these reductions is discussed i n m o r e detail i n N e l s o n et al. (1997), but is sufficient to create a deficit o f residual s a w m i l l chips i n the Interior based o n the average historic operating rate for the p u l p and paper industry i n the p r o v i n c e . Interior p u l p m i l l s w i l l l i k e l y l o o k to r o u n d w o o d chips to meet their fibre needs.  Tenure  Policy  W h i l e these initiatives affect the cost o f fibre, the government also influences the p u l p fibre market through its practice o f timber a l l o c a t i o n . It has been a long-standing feature o f government p o l i c y to a w a r d l o n g - t e r m cutting rights to t i m b e r processors. I n recent years, the government has responded w i t h several programs to c o m p l a i n t s that it is difficult for operators w i t h o u t cutting rights and new entrants to acquire fibre for p r o c e s s i n g . T h e m o s t important o f these, i n terms o f size, is the S m a l l B u s i n e s s Forest Enterprise P r o g r a m ' One case study f r o m the southern Interior suggested harvesting levels w o u l d drop by 3 1 % w h i l e overall operating costs w o u l d increase by 3 2 % , with roadbuilding costs increasing 8 7 % (Thibodeau, 1995). !  T h e M i n i s t r y o f Forests has to approve a forest management plan and grant a cutting permit before a licensee is a l l o w e d to harvest any timber.  ' Licensees still retain the right to adjust their overall harvest levels within prescribed amounts over one and five year terms.  167  ( S B F E P ) w h i c h p r o v i d e s short term cutting licenses. T h e s e are awarded o n the basis o f either the highest b i d or o n h o w w e l l a n a p p l i c a t i o n satisfies certain criteria such as the amount o f e m p l o y m e n t created or e c o n o m i c value added to the processed timber.  B e c a u s e most timber i s h e l d through l o n g term cutting rights, licensees d e v e l o p trading relationships and other arrangements w i t h other licensees to c o m e u p w i t h the best species m i x for their particular m i l l .  H o w e v e r , it has been a c k n o w l e d g e d that licensees are  uninterested i n trading fibre unless they c a n obtain fibre i n return ( B C M O F 1993). T h e result o f this is that there are v i r t u a l l y no substantial quantities o f fibre freely available o n the open market. T h e net effect has been to create a substantial secondary market for fibre that requires participants to have fibre to trade. T h i s i s best illustrated o n the C o a s t , where the V a n c o u v e r L o g M a r k e t m a i n l y functions as a trading m e c h a n i s m for participants to obtain desirable species and quality m i x e s for their fibre. T h e r e has been little such trading i n the Interior to date, although p u l p m i l l s i n the Interior do engage i n c h i p swaps to both rationalize transportation costs and to obtain certain species m i x e s . H o w e v e r , such c h i p swaps are o n a one-for-one basis; that is, there are r e c i p r o c a l f l o w s o f c h i p s w h i c h a v o i d s the need to set prices ( H e n r i c k s e n 1995).  T h e B C government also encourages such secondary trading (not a l l o f it need take p l a c e between p u l p m i l l s and s a w m i l l s ) through its p o l i c y o f a l l o c a t i n g t i m b e r directly. In some cases, f i r m s m a y a p p l y for a S m a l l B u s i n e s s S a l e even though they have n o intention o f u s i n g the logs directly or m a y even be unable to use a l l the l o g s they harvest. I n fact, the government n o w permits applicants to a p p l y for timber sales even i f they cannot use the logs directly but show that they can trade the l o g s for suitable fibre. S u c h arrangements are l i k e l y to take the f o r m o f long-term contracts or supply arrangements geared towards the particular requirements o f that licensee, further r e d u c i n g the v o l u m e s that m a y be available o n the open market.  168  T h e B C government has also undertaken to a w a r d the w o o d that w o u l d p r e v i o u s l y have been categorized as useable o n l y b y the p u l p industry. T h i s includes some s m a l l scale salvage programs, where the applicant enters the l o g g i n g area to retrieve l o g g i n g waste, and the granting o f t i m b e r licenses for s m a l l e r w o o d (sometimes termed p r o b l e m forest types). T h i s i n turn reduces the potential s u p p l y a v a i l a b l e to the p u l p industry. T h e net effect o f a l l these p o l i c i e s are to further reduce the ability o f market participants to respond to changes i n market conditions.  T o the extent that a l l o f the B C government's fibre is c o m m i t t e d , one l i k e l y response o f purchasers is to enter into long-term agreements w i t h specific suppliers and to d e v e l o p their o w n capacity to produce p u l p fibre f r o m w i t h i n their o w n cutting rights before turning to the open market. T h e size o f that market is l i k e l y to shrink to the point that purchasers m a y n o longer regard it as a significant source o f supply. T o the extent supply patterns b e c o m e fixed,  prices w i l l trend d o w n w a r d s as that market shrinks i n i m p o r t a n c e .  Stumpage Policy In Chapter 1, it was noted that the p r o d u c t i o n o f w o o d chips has gradually b e c o m e an integral part o f s a w m i l l s ' operations. F i g u r e 2 3 shows the average value o f l u m b e r and chips produced per c u b i c metre o f l o g input o n a quarterly basis, termed the Interior f r o m the third quarter o f 1990 through the end o f 1 9 9 8 .  150  Product Value, i n  F i g u r e 2 3 also  shows the average stumpage charge i n the Interior expressed as a percentage o f the product value for the same time p e r i o d , s h o w i n g the relative change i n stumpage values o v e r the past seven years.  ' Product value was constructed by using the price o f S P F random length lumber and m u l t i p l y i n g it by .250 (the L u m b e r R e c o v e r y Factor) and adding the c h i p value ( m u l t i p l y i n g c h i p prices by .15 or the C h i p Recovery Factor) per cubic metre o f l o g input. C l e a r l y , this measure w o u l d vary w i d e l y depending on company-specific products and recovery factors. It should be noted that to the extent a f i r m is operating i n areas with h i g h pulp l o g concentrations that the ability to pay w o u l d be shifted downwards significantly (although stumpage charges w o u l d also have to be adjusted to reflect m i n i m u m stumpage for pulp logs).  169  Figure 2 3 . Lumber and Chip Values per cubic metre o f L o g Input and S t u m p a g e a s P e r c e n t a g e o f T h o s e V a l u e s  0>  * E  9 0 ft  - • — Product Value - ® — Stumpage  T h e introduction o f ' S u p e r S t u m p a g e ' i n M a y o f 1994 c a n be c l e a r l y seen, w h i c h established higher stumpage rates w h e n l u m b e r prices exceeded certain v a l u e s  1 5 1  . Note  that e v e n after the stumpage reduction that took effect i n June, 1998, stumpage expressed as a percentage o f product v a l u e has been consistently higher over the past four years (1994-98) than i n the p r e v i o u s f o u r ( 1 9 9 0 - 1 9 9 3 ) .  152  G i v e n the increase i n costs  associated w i t h the Forest Practices C o d e , this suggests that the annual m a r g i n for stumpage payment i n the s a w m i l l i n g industry has shrunk i n recent years (a point echoed by B i n k l e y 1995).  T h e i m p l i c a t i o n s o f this p h e n o m e n o n for c h i p p r i c i n g are several-fold. F i r s t o f a l l , the stumpage system i n use for the past decade used o n l y l u m b e r prices to determine o v e r a l l  151  Specifically for the Interior, three different formula are used, where the cutoff is based on the Statistics Canada index used to track price movements for lumber produced i n the B C Interior. T h e net effect is to shift the effective rate up over higher prices.  152  A t the end o f 1997, stumpage as a percent o f product value was once again around 2 3 % , based on a lumber price o f approximately $ ( U S ) 3 0 0 per M b f and c h i p prices o f $ 8 5 per B D U .  170  stumpage l e v e l s .  1 5 3 1 5 4  W o o d c h i p prices were used to h e l p distribute charges w i t h i n  the Interior but d i d not affect the o v e r a l l l e v e l .  1 5 5  T h i s meant that w h e n c h i p prices  increased four-fold between 1994 and 1995, the increase had no effect o n stumpage rates although it c l e a r l y affected s a w m i l l ' s a b i l i t y to pay that stumpage. D i s c u s s i o n s w i t h industry participants suggest that the record prices p a i d for c h i p s helped c u s h i o n the effect o f the increased costs discussed earlier i n the face o f f a l l i n g l u m b e r prices. H o w e v e r , w h e n c h i p prices f e l l and c h i p shipments were curtailed, some s a w m i l l s f o u n d themselves unable to operate and either c l o s e d or reduced shifts as stumpage levels remained unchanged. T h i s was a significant change f r o m the p r e v i o u s system (pre-1987) where c h i p and l u m b e r revenues and costs were used i n d e t e r m i n i n g stumpage.  D u e i n part to the realization that c h i p revenues affect a s a w m i l l s ' revenue, the p r o v i n c i a l government incorporated c h i p prices i n stumpage determination w h e n it revised stumpage rates (though i n a somewhat c o n v o l u t e d fashion). T h e basic m e c h a n i s m o f the stumpage system remains unchanged, h o w e v e r , and whether or not stumpage rates w i l l be responsive to changes i n e c o n o m i c operating conditions remains a n o p e n question ( i n large part because costs are still not taken into account i n determining the o v e r a l l l e v e l o f charges).  S e c o n d , c h i p prices also effect the e c o n o m i c s o f m a r g i n a l operations. S e v e r a l s a w m i l l s stated that d u r i n g the peak i n c h i p prices they considered c o m m e r c i a l t h i n n i n g ; h o w e v e r , as prices f e l l , they c o u l d n o longer justify the operations ( M a y e s 1995, Pinette 1995). H i g h c h i p prices also substantially i m p r o v e d the a b i l i t y o f s a w m i l l s to b u y w o o d o n the o p e n  1 5 3  T h e specific formulas used i n determining stumpage are set forth i n both the Coast and Interior Appraisal manuals. In addition, there have been several explanatory papers written about the mechanics o f the stumpage system. A fairly concise view o f the stumpage system established i n 1988 can be found i n Deloitte, Haskins and Sells (1988).  1 5 4  T h i s was changed when stumpage rates were reduced i n June, 1988. A weighted average o f the appropriate lumber index and the index for c h i p prices i n B C are constructed for both regions i n establishing stumpage rates.  171  market, an important consideration where m a n y s a w m i l l s i n the Interior are i n c r e a s i n g l y r e l y i n g o n purchased w o o d . H o w e v e r , w h e n p u l p prices f a l l , u t i l i z a t i o n standards m a y require f i r m s to b r i n g out w o o d that is u n e c o n o m i c and that w o u l d be left b e h i n d based o n the costs o f harvesting a n d transport.  F i n a l l y , because o f the h i g h degree o f reliance b y the p u l p and paper industry o n residual chips, l o w l u m b e r prices c a n influence the a v a i l a b i l i t y o f p u l p fibre s u p p l y since f i r m s w i l l shut d o w n w h e n they are unable to operate profitably. T h e a b i l i t y o f p u l p m i l l s to offset the effects o f l o w e r l u m b e r prices b y p a y i n g m o r e for their fibre depends o n the state o f p u l p markets, and the t w o market c y c l e s m a y not necessarily c o i n c i d e (a h i g h p u l p market offsetting a l o w l u m b e r market). O n e consequence i n the past has been government intervention, as noted i n C h a p t e r 1, w h e n s a w m i l l s l o b b i e d the government to increase c h i p prices i n response to increased stumpage costs d u r i n g previous market c y c l e s w i t h l o w lumber p r i c e s .  The Interaction  1 5 6 1 5 7  Between  Formula  Pricing  and Firm  Behavior  F i n a l l y , f o r m u l a p r i c i n g has been a long-standing feature i n both the C o a s t a l a n d Interior p u l p fibre markets. I n the past, i t p r o v i d e d a s i m p l e means o f establishing fibre prices i n the face o f abundant supplies o f l o w cost residue that w o u l d otherwise be considered waste. It a l l o w e d s a w m i l l s to receive m o r e revenues w h e n the output p r i c e rose. H o w e v e r , this means o f determining prices is a crude measure o f demand. It fails to recognize the ' W o o d classified as suitable for pulp is charged at the m i n i m u m rate o f 2 5 cents per cubic metre and is incorporated i n determining the relative value o f a stand o f timber but does not affect the overall stumpage levels. ' "Resource M i n i s t e r B o b W i l l i a m s dropped several hints during the weekend about government assistance to B . C . ' s hard-pressed lumber i n d u s t r y . . . H e said independent sawmills are 'being exploited' by pulp companies w h i c h pay l o w prices for w o o d chips and that legislative action was one measure o f ensuring a better p r i c e . " (Prince George C i t i z e n 1974) ' " T h e other controversy i n B C (regarding the introduction o f the hew stumpage system i n 1987) surrounds w o o d chip pricing i n the Interior o f B C A l l pulp mills i n the Interior o f B C use w o o d chips generated as a by-product from s a w m i l l i n g operations. T h e sawmills w o u l d l i k e to see chip prices regulated (increased) by the Provincial Government, w h i l e the pulp mills are resisting such a move. O u r sense is that the government does not really want to get i n v o l v e d i n chip price  172  effects o f c h a n g i n g s u p p l y o n p r i c e s .  1 5 8  W i t h a l l types o f fibre b e c o m i n g scarcer,  and relative end product prices c h a n g i n g more q u i c k l y , p u l p companies m a y find themselves at a disadvantage to the extent they rely o n fixed formulae to establish prices that do not reflect changing relative prices o f available fibre. F o r e x a m p l e , the cost o f residual chips was greater than that o f r o u n d w o o d c h i p s o n the C o a s t d u r i n g parts o f 1994 and 1995. T h i s reflected i n part the fact that some o f the c h i p contracts were tied to l a g g e d prices o f p u l p w h i l e the r o u n d w o o d market was reflecting current d e m a n d and s u p p l y conditions. I n some cases c o m p a n i e s were unable to adjust their prices r a p i d l y enough and o v e r p a i d for their chips where they had made p r o v i s i o n a l payments i n the preceding time p e r i o d ( K u a n 1997).  H o w e v e r , f o r m u l a p r i c i n g , by l i n k i n g the input price o f w o o d chips to the output price for p u l p , has the virtue o f r e d u c i n g uncertainty for the p u l p m i l l o f one o f its major costs o f p r o d u c t i o n . P u l p m i l l s still l a r g e l y r e l y o n the spot market to set prices for p u l p , e v e n under long-term contracts, and as noted market p u l p prices have been v o l a t i l e i n recent years. T h i s practice helps reduce some o f the risk f r o m entering into fibre supply contracts w i t h suppliers.  The Effect  of Imperfect  Markets  on Social  Welfare  A s discussed i n C h a p t e r 2 , there is n o general rule about w h a t constitutes a Pareto o p t i m u m i n markets characterized b y space and market p o w e r . Instead, the set o f prices that m a x i m i z e social welfare depend o n the assumptions o f that particular m o d e l . I n the m o d e l d e v e l o p e d i n Chapter 4 , total surplus remained constant: the o n l y difference between the various p r i c i n g schemes l a y i n h o w the surplus was distributed a m o n g suppliers and between consumers and suppliers.  regulation and w o u l d just as soon ignore the problem i n the hopes that it goes away. T h i s w o u l d be the best course o f action for a l l concerned." (Kerr, 1989). ' A l f r e d Marshall is k n o w n for characterizing the determination o f prices as a k i n to that o f the action o f two scissors blades on representing demand and the other supply.  173  T h i s means that there are n o deadweight losses that are c o m m o n l y associated w i t h the presence o f market power. H o w e v e r , there are i m p l i c a t i o n s for the forest industry a n d p r o v i n c i a l e c o n o m y as a w h o l e a r i s i n g f r o m the historic b e h a v i o r o f w o o d c h i p prices w i t h i n the Interior market. T h e s e i m p l i c a t i o n s stem f r o m the dual role prices serve both as a means o f a l l o c a t i n g the surplus generated b y p u l p a n d paper p r o d u c t i o n , and i n the signals they send to the marketplace. W h a t m a y have been the effect o f a non-competitive e q u i l i b r i u m o n the Interior market?  A s A n d e r s o n (1985) has p o i n t e d out, w h e n t i m b e r tends to be C r o w n granted a n d a d m i n i s t r a t i v e l y priced, the corrective tendency o f increasing t i m b e r prices under market-based systems to signify increasing scarcity is absent. T o the extent prices are distorted, f i r m s m a y m a k e the w r o n g decisions. A n d e r s o n p o i n t e d out that one l i k e l y effect w o u l d be towards over-investment, as f i r m s w o u l d inaccurately perceive investment decisions as profitable based o n incorrect prices. T o what extent, then, m i g h t l o w c h i p prices have l e d to over-investment w i t h i n the p u l p and paper sector i n BC?  Investment  and Estimates  of  Rent  In order to e x a m i n e the question o f whether over-investment m a y have taken place, it is necessary to have some measure o f the e c o n o m i c performance o f the p u l p a n d paper sector. O n e such measure is the amount o f e c o n o m i c rent generated w i t h i n that sector. T h e definition o f R i c a r d i a n rent, the most c o m m o n rent associated w i t h forestry, is that it equals the f i n a l sale value o f timber less the costs o f harvesting it. C a l c u l a t i n g the a v a i l a b l e R i c a r d i a n rent i n the B C forest sector i n v o l v e s estimating the f i n a l sale value o f timber b y the value o f shipments o f the w o o d products industry a n d subtracting the w o o d industry's total harvesting costs, a n d d o i n g the same f o r the p u l p a n d paper i n d u s t r y .  159  M u c h o f this data is a v a i l a b l e o n an annual basis f r o m Statistics  C a n a d a , w h i c h reports expenditures o n materials, supplies, a n d fuel as w e l l as l a b o r expenditures b y industry group w i t h i n the forest sector. H o w e v e r , i t i s also necessary to calculate the cost o f capital used i n the industry. T h e standard approach i s to estimate the user cost o f capital, w h i c h i s T h e available data does not permit sectors to be regionally disaggregated.  174  usually constructed as the opportunity cost o f the capital stock plus depreciation. T h e opportunity cost requires c h o o s i n g a rate o f return w h i c h c a n i n c l u d e a r i s k p r e m i u m . F o r these calculations, the average annual p r i m e rate plus 2 % for risk was used as the rate o f return. T h e detailed m e t h o d o l o g y and calculations b e h i n d the estimates c a n be f o u n d i n G r a f t o n , L y n c h , and N e l s o n (1998).  E a r l i e r w o r k o n l y estimated rents i n the s o l i d w o o d sector o f B C ( C o p i t h o r n e 1979; P e r c y 1987; Grafton, L y n c h and N e l s o n 1998). W h y m i g h t rents exist i n the p u l p and paper sector as w e l l ?  P u l p and paper m i l l s i n B C c o n s u m e some fibre directly (approximately 1 7 % - see T a b l e 5) and resource rents m a y appear for the same reason they appear i n the s o l i d w o o d sector. M o r e importantly, as discussed i n the previous chapter, has been the effect o f an " a r t i f i c i a l " market e q u i l i b r i u m creating the p o s s i b i l i t y o f " m o n o p o l y " rents as l o w e r c h i p prices effectively transferred producer surplus f r o m s a w m i l l s to p u l p m i l l s (note that i f s a w m i l l s had r e c e i v e d higher prices this w o u l d result i n h i g h e r estimates o f the resource rent).  F i g u r e 2 4 shows y e a r l y estimates o f rent i n the s o l i d w o o d and p u l p and paper sectors a l o n g w i t h the charges for C r o w n T i m b e r .  1 6 0  Several features are i m m e d i a t e l y apparent, most noticeably the  increasing amplitude) o f the estimates for both the s o l i d w o o d and p u l p and paper sector. T h i s i n part i s due to the influence o f inflation, but also represents the i n c r e a s i n g size o f both industries, although the s o l i d w o o d sector has consistently been larger than the p u l p and paper sector i n terms of rent. I n addition, it c a n be seen that both sectors are reasonably w e l l correlated o v e r m o s t o f the time p e r i o d i n question, w i t h the e x c e p t i o n o f the last few years. T i m b e r charges appear fairly s y n c h r o n i z e d w i t h rent estimates over m u c h o f the p e r i o d w i t h the e x c e p t i o n o f the past few years w h i c h c o i n c i d e s w i t h the introduction o f the C V P system. M o s t noticeable, though, are the large negative estimates for the p u l p and paper sector i n the early 1980's a n d again i n the early 1990's.  ' 1994 and 1995 are estimated based on historic relationships between shipment values and rent estimates as the Statistics Canada data used to derive earlier values was not available. 175  F i g u r e 2 4 . A n n u a l R e s o u r c e R e n t in B r i t i s h C o l u m b i a b y S e c t o r , a n d T i m b e r C h a r g e s in 0 0 0 ' s of Dollars $3,000,000 $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 $0 1935  ($500,000? 9 p ($1,000,000) ($1,500,000) ($2,000,000) •Solid Wood  -®  Pulp and Paper  Charges  Source: Statistics Canada 2 5 - 2 0 1 ; Statistics Canada capital stocks special extraction  Table 17 separates the rent estimates into three different periods that correspond to changes i n the stumpage system u s e d by the p r o v i n c e . T h e 1994-95 rent numbers are estimated and i n current d o l l a r s .  161  E a c h entry represents the c u m u l a t i v e total o f rent o r  charges for that p e r i o d .  Table 17. Estimates of Rent and Charges over Three Different Periods (in millions of current and constant $) Period  1970-80 1980-87 1988-93 Total  1994-95  Solid Wood Rent i n Current $  $4,426 $2,490 $6,713 $13,269 (all estimates in current dollars)  Solid Wood Rent i n Constant 1986$  $8,551 $2,362 $5,551 $16,464  $3,612  Pulp & Paper Rent i n Constant 1986$  $1,422 ($1,477) ($789) ($1,336)  $1,412  Total Rent i n Constant 1986$  $9,972 $915 $4,762 $15,560  $5,024  Charges in Constant 1986$  $3,953 $1,385 $3,450 $8,788  $3,991  Charges A s a Percent o f Estimated Total Rent  40% 151% 75% 57%  80%  .77 can be used as an approximate conversion figure to translate current $ into Constant $.  176  Table 18 presents the same i n f o r m a t i o n , e x c l u d i n g p u l p and paper rents, o n a per c u b i c metre basis to account for c h a n g i n g harvest levels o v e r the different periods. T h e amount o f rent has, unsurprisingly, v a r i e d d r a m a t i c a l l y throughout the years, reflecting for the most part c y c l i c a l changes i n l u m b e r and p u l p prices (see Figure 2). W h e n the effects o f inflation are r e m o v e d , 1  recent h i g h l u m b e r and p u l p prices c a n b e seen to be comparable to those i n earlier years. T h e l e v e l o f rent c o l l e c t i o n has d r a m a t i c a l l y increased i n recent years; i n fact, these estimates suggest that i n four o f the past eight years, more rent was c o l l e c t e d through t i m b e r charges than was available ( i n theory) i n the s o l i d w o o d sector. C l e a r l y , such l e v e l s o f rent capture cannot be sustained i n the l o n g run w i t h o u t i m p l i c a t i o n s for capital re-investment.  Table 18. Estimates of Resource Rent and Timber Charges on a Per Cubic Metre Basis, 1970-95 Period Harvest Charges in Solid Wood Rent in (millions of m ) Constant 1986$ / m Constant 1986$ / m 3  1970-80 1980-87 1988-93 Total / Average  1994-95 (est. in current $)  3  714 508 479 1,701  $11.98 $4.65 $11.58 $9.68  $5.54 $2.73 $7.19 $5.17  152  $23.76  $26.24  3  T h e large estimates o f "negative" rent for the p u l p and paper industry reflect the capital intensity o f the industry and the fact that prices often f a l l to near cash costs d u r i n g recessions w h e n f i r m s are unable to c o v e r their costs o f c a p i t a l .  162  O v e r the m a r k e t c y c l e , h o w e v e r , f i r m s w o u l d recover  those costs g i v e n that the o p t i m a l l e v e l o f capacity existed i n the industry. Persistent losses, h o w e v e r , w o u l d be a s i g n for s o m e capacity to e x i t the market.  Consequences  of Uncollected  Rent  These estimates o f rent also suggest that significant amounts o f rent were not c o l l e c t e d through timber charges over the p e r i o d 1970 through 1980. A s noted earlier, l e a v i n g some rent u n c o l l e c t e d w i l l not affect the l e v e l o f output. H o w e v e r , to the extent the r e m a i n i n g rent represents a payment  177  i n excess o f a l l e c o n o m i c costs, those payments m a y have a l o n g t e r m i m p a c t . Suggestions that have been made i n c l u d e : higher wages; rent dissipation; X - i n e f f i c i e n c y ; increased f i r m profitability; and excess w o o d - p r o c e s s i n g capacity. E x a m i n a t i o n s o f some o f these p o s s i b i l i t i e s have noted that w h i l e wages d o appear h i g h e r i n the forest sector, historic rates o f return f o r B C companies have been b e l o w their peers f o r m u c h o f the past decade ( S c h w i n d t , 1979; Pearse, 1976; C o p i t h o r n e , 1979; P r i c e W a t e r h o u s e , 1996). product f o r forestry c o m p a n i e s operating i n B C .  Table 19 s h o w s  the rates o f return b y  1 6 3  Table 19. Return on Capital Employed by Product 1986  1987  1988  1989  1990  1991  Lumber  7.6  18.7  6.3  4.0  (4.0)'  (6.4)  Market Pulp  9.5  22.2  22.8  20.4  7.5  16.8  18.3  16.4  4.0  1.3  Newsprint  1992  1993  1994  1995  1996  28.8  21.5  10.5  8.6  (4.3)  (2.1) . (8.1)  0.5  10.0  (9.0)  (2.9)  (4.0)  (1.2)  5.8  5.3  9.0  (3.5)  Source: Price Waterhouse, 1996  O n e possibility is that the rent retained by the firms signified i n d i v i d u a l l y the m a r g i n a l profitability of increasing capacity. A l t h o u g h resource rent is a price-determined e c o n o m i c residual f r o m an industry perspective, it appears as a cost o f p r o d u c t i o n to i n d i v i d u a l firms. I n the case o f uncollected rent, the excess returns are l i k e l y to be attributed to the other c o m m o n l y fixed factor, capital, and p r o v i d e the incentive to expand output by investing i n additional capital. T h e r e has been some institutional bias b e h i n d this; one means o f increasing harvesting rights i n earlier years was to increase the s a w m i l l capacity and apply to the government for the additional w o o d requirements. H o w e v e r , despite the i n d i v i d u a l firm's perceptions, firms i n aggregate f a c e d o v e r a l l constraints i n harvest l e v e l s . A s early as 1980, M i n i s t r y officials w i t h i n B C were w a r n i n g o f an eventual f a l l - d o w n effect as harvest levels dropped to reflect the m o v e into s e c o n d - g r o w t h forests  162 £ ) } f f assumptions about the interest rate w o u l d lead to different estimates. H o w e v e r , even setting the risk p r e m i u m to 0 still yields negative estimates over the period 1970-93 for the pulp and paper industry i n B C . e r e n t  163  B a c k g r o u n d information used to prepare these reports distinguish market p u l p production between the B C Coast and the Interior. T h e Interior has consistently been more profitable than the Coast over the past eight years as measured by operating earnings expressed on a per metric tonne basis (Price Waterhouse, various).  178  (  ( M i n i s t r y o f Forests 1984). T h e end result has been a n over-investment i n capacity, w i t h the r e m a i n i n g rent dissipated across n o w excess capacity. T h i s is the equivalent o f the c o m m o n resource property i n fisheries that leads to over-investment i n f i s h i n g effort until returns and the stock are d r i v e n d o w n to the p o i n t where n o rent remains. H e r e , f i r m s undertook investments predicated o n incorrect assumptions about w o o d costs that d i d not y i e l d a sufficient return.  A d d i n g the current estimates o f rent (for the t w o years 1994-95) to the estimates f r o m the p r e v i o u s t w o periods (1980-87 and 1988-93) s h o w that the p u l p a n d paper industry lost a p p r o x i m a t e l y $1.2 b i l l i o n over the entire t i m e p e r i o d . U s i n g the same method, the s o l i d w o o d sector w o u l d have earned $10.7 b i l l i o n o v e r those 17 years (see T a b l e 16). T h i s result suggests that there has been a n over-investment i n p u l p and paper capacity i n the province. F r o m the p u l p m i l l ' s perspective, increasing capacity appeared profitable at the m a r g i n u s i n g the p r e v a i l i n g " m a r k e t " prices f o r residual w o o d c h i p s . H o w e v e r , f r o m a n e c o n o m i c perspective, the "market" price for w o o d chips d i d not reflect the actual e c o n o m i c opportunity cost o f that fibre. T h e end result was a c o l l e c t i v e over-investment i n p u l p capacity.  T h e i m p l i c a t i o n s , then, are quite dramatic. Short term government intervention i n the Interior residual c h i p market, designed to address specific concerns, h a d unintended consequences e v e n after the government ostensibly w i t h d r e w f r o m i n v o l v e m e n t i n the market. A s prices o f chips remained essentially frozen, reflecting the p e c u l i a r characteristics o f both the c o m m o d i t y and market structure, f i r m s d i d not receive the types o f signals they otherwise w o u l d reflecting changes i n market scarcity, w i t h the result that short-term prospects l e d , i n aggregate, to l o n g - t e r m losses.  179  6. CONCLUSIONS The world of business is a world of oligopoly. No inductive leap (a la F. Knight, 1921) from pure competition is truly feasible for policymakers, save a leap into the world of oligopoly... (Greenhut and O h t a 1 9 9 3 : 3 9 8 )  In s u m m a r y , the pattern o f prices observed i n the B C Interior w o o d c h i p market o v e r the period 1987 to 1996 cannot be e x p l a i n e d b y a s i m p l e m o d e l o f competitive b e h a v i o u r . Instead, the l e v e l and pattern o f prices i n the w o o d c h i p m a r k e t reflect both the significant influence o f government intervention i n that market as w e l l as non-competitive b e h a v i o u r . A m o d e l o f spatial p r i c e d i s c r i m i n a t i o n shows h o w price coordination c a n effectively lead to n o n - c o m p e t i t i v e outcomes. I n the Interior w o o d c h i p market, p r i c e controls enacted b y the government i n the early stages o f the market ( f r o m the early 1960s through 1980), c o u p l e d w i t h restrictions o n w h o c o u l d purchase c h i p s , effectively froze the market. N o i n d i v i d u a l purchaser h a d any incentive to deviate f r o m historic supply arrangements so l o n g as other f i r m s also adhered t o the same arrangements. I n terms o f general e c o n o m i c theory, the results suggest that i n this case, a d e l i v e r e d p r i c i n g system reduced effective competition b y permitting firms to engage i n tacit coordination.  T h e m o d e l o f spatial price d i s c r i m i n a t i o n also showed that these types o f outcomes have the characteristics o f a prisoner's d i l e m m a . S u c h e q u i l i b r i a can be inherently unstable, especially as firms change their beliefs about the environment i n w h i c h they operate. V a r i o u s e m p i r i c a l tests show that prices i n the Interior market were b e l o w those i n other markets, and r e m a i n e d relatively fixed until a b r e a k d o w n o f historic supply arrangements. T h i s change i n firm b e h a v i o u r and beliefs l e d to a rapid increase i n prices as firms reverted to the d o m i n a n t e q u i l i b r i u m i n the P r i s o n e r ' s d i l e m m a ( w h i c h i n this case is associated w i t h h i g h e r prices).  W h a t m i g h t happen i n the future? T h e r e is a considerable degree o f indeterminacy o f c h i p p r i c i n g that is not f o u n d i n p u l p w o o d p r i c i n g . W h i l e l u m b e r prices m a y p r o v i d e some  theoretical f l o o r for c h i p prices, the increasing v o l a t i l i t y o f l u m b e r markets, c o u p l e d w i t h the increased costs noted above, m a k e it difficult to identify the m i n i m u m prices necessary for s a w m i l l s to r e m a i n profitable o v e r the l o n g run. T h i s indeterminacy p r o v i d e s a great deal o f scope for b a r g a i n i n g o v e r c h i p prices, w h i c h m a y be one reason c h i p p r i c i n g has been so contentious i n the past (as seen i n C h a p t e r l ) .  1 6 4  C h i p p r i c i n g w i l l continue to  be a major issue g i v e n its role i n affecting the a b i l i t y o f s a w m i l l s to pay stumpage and consequently operate, the importance o f operating l e v e l s for stumpage revenues to the government, and the fact that fibre costs are the most significant issue f a c i n g p u l p and paper f i r m s i n the p r o v i n c e today. C o n s i d e r the fact that at historic l e v e l s o f p r o d u c t i o n o f around six m i l l i o n B D U s annually, a $ 1 0 increase i n the p r i c e per unit raises revenues i n the Interior s a w m i l l industry b y $ 6 0 m i l l i o n , and these revenues f l o w straight to the b o t t o m line.  A s noted above, residual chips w i l l n o l o n g e r p r o v i d e enough raw material for the Interior p u l p industry ( N e l s o n et a l . 1997). W h i l e their a v a i l a b i l i t y m a y v a r y d e p e n d i n g o n s a w m i l l operating rates, shipments to the Coast, and the export market, a n i n c r e a s i n g amount o f fibre has c o m e and w i l l continue to c o m e f r o m the u t i l i z a t i o n o f r o u n d w o o d c h i p s . I n effect, they w i l l act as the surge (or buffer) for p u l p fibre supply, m u c h as is the case i n the P a c i f i c N o r t h w e s t . H o w these fibre sources are d e v e l o p e d , h o w e v e r , c a n have important i m p l i c a t i o n s for the Interior industry. B o t h the inherent market structure, c o u p l e d w i t h government p o l i c y regarding b o t h harvesting and stumpage, have l e d to a n i n c r e a s i n g l y inflexible market. U n c h a n g e d , this i s l i k e l y to lead to a market that alternates between periods o f relative quiescence and periods o f sharp v o l a t i l i t y .  T h e structure o f the p u l p and paper industry, g i v e n the regional concentration and relative size o f most p u l p m i l l s , i s c o n d u c i v e to the exercise o f m a r k e t p o w e r . T h i s i s offset  164  A recent issue o f M a d i s o n ' s Canadian L u m b e r Reporter alludes to the ongoing tension i n this market with an article entitled " C h i p W a r s " , w h i c h discusses the importance o f c h i p revenues to the sawmill industry without c o m i n g to any conclusions ( M a d i s o n ' s , N o v e m b e r 29, 1996).  181  somewhat b y the p a r t i c i p a t i o n o f other purchasers f r o m outside the r e g i o n , n a m e l y the export market and p u l p m i l l s o n the B C C o a s t , a l t h o u g h the export o f w o o d c h i p s , as noted i n C h a p t e r 1, has l o n g been a contentious i s s u e .  165  T o the extent s a w m i l l s a n d p u l p m i l l s continue to focus o n c h i p prices a n d regard p r i c i n g as a z e r o - s u m p r o p o s i t i o n ( i n other w o r d s , any increase i n p r i c e c o m e s straight o f f one party's bottom l i n e and increases the other's), their relationship w i l l continue to be adversarial. I n addition, so l o n g as participants regard the system as b e i n g unresponsive o r i n f l e x i b l e , the government w i l l continue to face pressure f r o m both sides as each propose their o w n s o l u t i o n to the p r o b l e m s o f p r i c i n g a n d s u p p l y . H o w e v e r , as noted i n this thesis, past government intervention has often had unintended consequences, a n d m o r e intervention w o u l d l i k e l y l e a d to even less f l e x i b i l i t y f o r participants i n the c h i p market. H o w e v e r , g i v e n that c h i p prices have little i m p a c t o n production decisions, w h y s h o u l d p o l i c y makers care whether the market is competitive or not?  T h e r e are several reasons. A s discussed i n the p r e c e d i n g chapter, incorrect prices can l e a d firms to m a k e incorrect investment decisions. B u t perhaps m o r e i m p o r t a n t l y , c o m p e t i t i v e markets p r o v i d e a means o f allocating goods a n d distributing funds that are m o r e responsive than the c o m m a n d a n d control techniques associated w i t h government regulation.  A competitive market promotes e c o n o m i c efficiency i n t w o w a y s : (a) allocative efficiency; and (b) technical o r x-efficiency. In terms o f the w o o d c h i p market, this means that market prices send accurate signals about the u t i l i z a t i o n o f the resource. Forest p o l i c y i n B C has been characterized b y a reliance o n regulations to achieve e c o n o m i c goals. O n e o f these goals i s i m p r o v i n g the u t i l i z a t i o n o f the resource, processing w o o d that w o u l d otherwise be  165  G i l l i s (1989) notes that debates over the export o f pulp w o o d i n Ontario and Quebec i n the first part o f the twentieth century were very similar, and notes that the main reason local pulp mills were unhappy with exports was that U S buyers effectively paid higher prices.  182  considered waste. T o encourage the use o f this fibre, the government mandates the recovery o f certain v o l u m e s . T h i s w o o d m a y face f u l l stumpage charges o r q u a l i f y for m i n i m u m stumpage (set at 2 5 cents per c u b i c metre). I n a d d i t i o n , the v o l u m e s harvested m a y or m a y not count against a licensee's a l l o w a b l e cut. H o w e v e r , it has been s h o w n that such u t i l i z a t i o n standards m a y require firms to b r i n g i n u n e c o n o m i c material; that i s , the fibre costs m o r e to harvest and transport than it is w o r t h ( U h l e r and M o r r i s o n 1986). A t times, the costs associated w i t h processing such material c a n lead to a curtailment i n l o g g i n g a c t i v i t y , as firms cannot profitability process the w h o l e stand g i v e n the u t i l i z a t i o n constraints.  A n o t h e r characteristic o f a n efficient market is its ability to equilibrate d e m a n d and supply. In a freely open market, prices adjust to b r i n g supply a n d d e m a n d into balance.  Because  m u c h o f the timber w i t h i n B C i s tied up i n l o n g term cutting right, there is not m u c h available o n the open market. T h i s reduces the a b i l i t y o f participants to turn to that market to meet their needs.  T h e practice o f granting long-term cutting rights to specific facilities also frustrates the k i n d o f responses that w o u l d be expected under c o m p e t i t i v e markets. F o r e x a m p l e , the K r a f t process requires t w i c e the amount o f p u l p w o o d per unit o f output c o m p a r e d to the m e c h a n i c a l p u l p process. It m a y be that s w i t c h i n g p u l p i n g processes w i l l be one o f the w a y s the p u l p and paper industry adjusts to the decreased a v a i l a b i l i t y o f fibre. T o the extent v o l u m e s are tied up i n tenures c o m m i t t e d to certain facilities, these type o f adjustments w i l l be retarded.  A n e x a m p l e o f some o f these forces at w o r k c a n be seen i n the short-term collapse o f the p u l p l o g market o n the C o a s t i n 1996 ( T r u c k L o g g e r 1996). Integrated c o m p a n i e s o n the B C Coast, fearing a potential shortfall o f p u l p fibre d u r i n g the market peak i n 1995, i m p o r t e d significant quantities o f p u l p l o g s f r o m outside B C as that was the o n l y market that c o u l d p r o v i d e significant v o l u m e s q u i c k l y . H o w e v e r , w h e n p u l p prices c o l l a p s e d ,  firms f o u n d themselves w i t h soaring inventories and the domestic market for p u l p logs c a m e to a v i r t u a l standstill ( T r u c k L o g g e r , 1996). T h i s i n turn l e d to a sharp r e d u c t i o n i n l o g g i n g , and calls for the government to reduce stumpage until the p u l p l o g price recovered as prices for p u l p l o g s were less than their harvesting costs. I n some case, f i r m s continued to i m p o r t fibre that was n o w substantially m o r e expensive than domestic f i b r e . T h e same c a l l s for changes i n stumpage have been made i n the Interior, where f i r m s w i t h a h i g h proportion o f p u l p material i n their cutting areas have made proposals to the M i n i s t r y to change the stumpage system. T h e y have argued that they s h o u l d face reduced stumpage charges to reflect their relatively higher cost and l o w e r v a l u e d t i m b e r stands (although under the current system such proposals w o u l d s i m p l y increase charges w i t h i n other regions o f the p r o v i n c e ) ( R e p a p 1996).  A n o t h e r benefit f r o m competitive markets is that f i r m s , i f they feel w o o d c h i p v o l u m e s are freely available o n the open market, w i l l carry less inventories, r e d u c i n g the amount o f capital tied up w h i l e i m p r o v i n g the quality o f the p u l p produced.  T h e p r o v i n c i a l government has a c l a i m to the rents generated b y the forest industry through stumpage payments. B e c a u s e most o f this stumpage f l o w s f r o m the p r i m a r y processors, s a w m i l l s are responsible for p a y i n g m o s t o f the stumpage. A t the same time, the stumpage system does not use p u l p fibre revenues to establish the l e v e l o f c h a r g e s .  166  Despite the advent o f market p u l p made f r o m d e - i n k e d paper and the development o f n e w plantations, the consensus w i t h i n the p u l p a n d paper industry appears to be that w h e n c y c l i c a l changes are r u l e d out that fibre costs w i l l continue to increase. Increased w o r l d trade i n fibre i s expected as supplies decrease w i t h i n traditional processing areas. A t the same time, technological advances permitting the use o f l o w e r grade p u l p i n paper-making  166  T h i s may change with the introduction o f new stumpage calculations. H o w e v e r , modification o f the current system depends i n part o n the impact it may have o n the Softwood L u m b e r Agreement ( S L A ) with the U S , and it is not clear yet whether the stumpage changes w i l l meet with U S approval.  184  reduce the ability o f firms i n B r i t i s h C o l u m b i a to charge the traditional p r e m i u m for their higher quality pulp. A t the same time, it is reasonable to expect that a larger p r o p o r t i o n o f fibre w i l l be f l o w i n g into the p u l p and paper sector g i v e n a d e c l i n e i n w o o d quality. U n d e r such circumstances, it is l i k e l y that i n the future the government m a y seek to establish a stumpage system that uses p u l p fibre values. A g a i n , a c o m p e t i t i v e market p r o v i d e s an accurate assessment o f those v a l u e s . '  67  F i n a l l y , competitive markets also p l a y a distributive role. A s noted earlier, a feature o f the m o d e l developed was that total p r o d u c t i o n remained unchanged between the various e q u i l i b r i a , but the distribution o f the surplus changed d r a m a t i c a l l y . F r o m the perspective o f a s a w m i l l , higher c h i p prices are an u n a l l o y e d benefit, i m p r o v i n g their b o t t o m l i n e , w h i l e a p u l p and paper m i l l sees t h e m as w r e a k i n g h a v o c o n their b o t t o m l i n e , turning t h e m into u n e c o n o m i c producers. A s noted above, the government also has a n interest i n any rents generated b y p u l p and paper p r o d u c t i o n . S t i g l e r (1971), i n his s e m i n a l w o r k , a d v a n c e d the  i  theory that most government regulation i s a response to agents attempting to further their e c o n o m i c interests. Forest p o l i c y i n B C has l o n g been m a r k e d b y p o l i t i c a l c l a i m s to the w e a l t h generated b y the forest ( M a r c h a k 1983; S c h w i n d t a n d H e a p s 1 9 9 6 ) .  168  Groups  establish c l a i m s to the resource rent through attempts to influence government i n v o l v e m e n t i n the a l l o c a t i o n and p r i c i n g o f fibre, and the p u l p fibre market is no different. C o m p e t i t i v e markets provide a means o f a l l o c a t i n g and p r i c i n g fibre, relatively free f r o m costly p o l i t i c a l involvement.  In terms o f p o l i c y recommendations, the results suggest that i n general the government s h o u l d m i n i m i z e its direct regulation o f the w o o d c h i p market, a n d i n particular, any  167  Accurate values for pulp fibre also are important i n determining appropriate transfer prices. T h i s is an area o f particular concern as a significant portion o f pulp produced i n B C is transferred to an affiliate or partner i n a joint venture elsewhere, a l l o w i n g for the companies to shift profits between different jurisdictions. A n example o f this is the dispute between Crestbrook P u l p and Paper and Revenue Canada (Pratt and Urquhart, 1994).  1 6 8  B C is by no means unusual. Hansing and W i b e (1992) show how laws meant to ration timber i n Sweden have helped the existing industry to deter entry.  185  regulations h a v i n g to d o w i t h p r i c i n g and/or restrictions o n where w o o d c h i p producers c a n market their chips. T h e evidence suggests that the Interior market c a n function c o m p e t i t i v e l y ( g i v e n the e x i s t i n g market structure during the study p e r i o d ) .  169  The  existence o f a large market f o r w o o d c h i p s , not often present elsewhere i n C a n a d a , offers an opportunity for p o l i c y makers to help establish c o m p e t i t i v e prices for p u l p f i b r e . T h i s offers m a n y o f the advantages outlined above, as w e l l as p r o v i d i n g m o r e reliable values that c a n be used i n d e c i s i o n - m a k i n g . F o r e x a m p l e , the government has indicated a preference for more intensive silvicultural treatments. B e c a u s e o f the l o n g time frame i n v o l v e d , the e c o n o m i c payoffs tend to be m a r g i n a l . O n e o f the w a y s i n w h i c h these treatments c a n b e c o m e profitable is through the use o f various t h i n n i n g techniques that provide v o l u m e s o f w o o d earlier i n the treatment period than the standard practice o f harvesting at maturity. R e c o g n i z i n g the true e c o n o m i c value o f this f i b r e , m u c h , o f w h i c h i s suitable for p u l p i n g , w i l l help to determine where s u c h treatments are feasible. I n a d d i t i o n , the c h o i c e o f end-product m i x (for e x a m p l e , the p r o p o r t i o n o f s a w l o g versus p u l p w o o d quality t i m b e r ) is also dependent o n the relative values o f the products i n v o l v e d .  A n o t h e r consideration the government faces i s i n establishing the trade-offs between the benefits and costs o f e n v i r o n m e n t a l regulation i n the forest industry. F o r e x a m p l e , the government is currently c o n s i d e r i n g regulations that stipulate h o w m u c h debris s h o u l d be left o n site after l o g g i n g operations (this coarse w o o d y debris b e i n g considered i s different f r o m the u t i l i z a t i o n standards currently i n place). S o m e o f this debris m a y be suitable for p u l p fibre, and to the extent the government restricts f i r m s f r o m u t i l i z i n g it, i t places additional pressure o n m a i n t a i n i n g harvest l e v e l s . E s t a b l i s h i n g appropriate values w i l l a i d i n m a k i n g these k i n d s o f decisions.  T h e government i s l i k e l y to continue its tradition o f encouraging e c o n o m i c development through granting access to w o o d fibre. H o w e v e r , m u c h o f the u n c o m m i t t e d w o o d fibre  169  T h i s includes ownership patterns, the number and distribution o f pulp mills and sawmills, control of cutting rights, and harvest levels.  186  r e m a i n i n g today is n o n - c o n v e n t i o n a l (e.g. i s s m a l l , c r o o k e d , o r insect-damaged); the p u l p and paper industry is one o f the most l i k e l y consumers o f such f i b r e . T h i s thesis has also s h o w n that market p o w e r is a perennial c o n c e r n throughout p u l p fibre markets i n C a n a d a ( G e l d h a r t a n d C a r r o l l 1980, O l s o n 1989, R u n y o n 1983, N a u t i y a l et a l . 1995). I f p u l p and paper firms receive access to fibre through l o n g - t e r m c o m m i t m e n t s such as p u l p w o o d agreements, market concentration and the potential for the exercise o f market p o w e r can be expected to g r o w . T h e government s h o u l d encourage the development o f additional sources o f fibre outside o f integrated companies and should not permit the u t i l i z a t i o n o f unused P u l p w o o d A g r e e m e n t s .  T h e p r o v i n c i a l government m a y also want to r e v i e w its p o l i c i e s o n p r i c i n g for p u l p fibre, r e c o g n i z i n g that historic prices m a y not be a g o o d predictor for future p r i c i n g . T h e tendency i n the past, as noted i n C h a p t e r 1, has been to m e c h a n i c a l l y l i n k charges to output prices. T h e government s h o u l d also take into account the variability i n end-product prices i n designing a n appropriate system o f charges, r e c o g n i z i n g that the a b i l i t y to pay for p u l p fibre differs substantially over the market c y c l e .  T h e government s h o u l d also d e v e l o p a consistent export p o l i c y . T h e current practice o f o n again, off-again exports m i n i m i z e s the benefits o f h a v i n g a n effective market outlet for suppliers, as f o r e i g n customers regard B C chips as unreliable and p r i c e t h e m a c c o r d i n g l y . A s discussed above, analysts have forecast i n c r e a s i n g prices i n the g l o b a l marketplace for p u l p fibre. A c c e s s to this market offers the p o s s i b i l i t y o f increased c o m p e t i t i o n i n the p r o v i n c i a l p u l p fibre market and c o u l d offset the effects o f l o c a l concentration. I f the p r o v i n c e reduces the ability o f f i r m s to participate i n the export market, domestic c h i p prices w i l l be l o w e r i n the l o n g run.  T h e issue o f whether or not residual chips s h o u l d be retained to p r o v i d e fibre supply for domestic p u l p m i l l s is another manifestation o f the mercantilist's debate about p r o v i d i n g j o b s by restricting i m p o r t s ( i n this case, exports). A s M a r g o l i c k and U h l e r ( 1 9 9 2 ) s h o w ,  these p o l i c i e s p r o v i d e direct benefits to the processors ( i n this case p u l p m i l l s ) but the benefits are o u t w e i g h e d b y the losses suffered b y the producers and the government. T h e benefits o f the export market i n p r o v i d i n g a c o m p e t i t i v e outlet should be r e c o g n i z e d .  1 7 0  T h e previous chapter showed that the most l i k e l y outcome o f this p o l i c y o f retaining fibre for domestic use has been an over-investment i n p u l p and paper capacity. R e s t r i c t i n g exports n o w w i l l not address the fundamental issues u n d e r l y i n g the l o n g - t e r m competitiveness o f the p u l p and paper industry i n the p r o v i n c e .  F i n a l l y , there has to be a r e c o g n i t i o n that the d e f i n i t i o n o f p u l p fibre is a l w a y s c h a n g i n g due to new t e c h n o l o g y . It depends o n the particular