@prefix vivo: . @prefix edm: . @prefix ns0: . @prefix dcterms: . @prefix dc: . @prefix skos: . vivo:departmentOrSchool "Forestry, Faculty of"@en ; edm:dataProvider "DSpace"@en ; ns0:degreeCampus "UBCV"@en ; dcterms:creator "Nelson, Harry"@en ; dcterms:issued "2009-07-03T17:51:14Z"@en, "1999"@en ; vivo:relatedDegree "Doctor of Philosophy - PhD"@en ; ns0:degreeGrantor "University of British Columbia"@en ; dcterms:description """The large scale and transportation costs of most wood producing industries, especially in the pulp and paper sector, typically leads to high levels of concentration in regional markets for wood fibre. This in turn has meant that the possible exercise of market power in forest product input and output markets has been long recognized. A recurring issue i n British Columbia has been the prices paid by local pulp mills for wood chips used to produce pulp. The provincial government has directly and indirectly regulated the pulp fibre market in the Interior of the province both during its inception and throughout much of the past forty years. Government intervention led to a non-competitive outcome marked by l ow prices for wood chips that were characterized by the fact that prices paid to suppliers were invariant with respect to distance. A model shows how this particular equilibrium was inherently unstable, as evidenced by prices increasing four-fold after a change in firm behaviour. Because the province owns of most of the forest land in the province it has developed a set of goals concerning the provincial forest industry that include providing employment, maintaining community stability, and collecting revenues from the harvest of timber on behalf of the public. The provincial government faces a series of policy questions regarding the forest industry in terms of harvest levels, regulation, trade policy, and stumpage design. If past trends continue, pulp and paper mills are likely to become the largest users of the forest resource within the next five years, while provincial forest policy remains focused on the production o f solid wood products. At the same time, increased fibre costs due to a combination of government initiatives and decreasing fibre availability are affecting the entire forest industry in BC . For pulp and paper mills their fibre costs can determine their competitiveness i n world markets. How the government responds to these issues will affect both fibre flows within the sector as well as the future structure of the forest sector."""@en ; edm:aggregatedCHO "https://circle.library.ubc.ca/rest/handle/2429/10063?expand=metadata"@en ; dcterms:extent "13266605 bytes"@en ; dc:format "application/pdf"@en ; skos:note "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 EVIDENCE FROM THE BC INTERIOR PULP FIBRE M A R K E T by HARRY NELSON A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY In THE FACULTY OF G R A D U A T E STUDIES The Faculty of Forestry Department of Forest Resources Management We accept this thesis as conforming To the required standard T H E U N I V E R S I T Y O F B R I T I S H C O L U M B I A July 1999 © Harry Ne l son 1999 A B S T R A C T T h e large scale and transportation costs o f most w o o d producing industries, especial ly i n the pulp and paper sector, typica l ly leads to h igh levels o f concentration i n regional markets for w o o d fibre. T h i s i n turn has meant that the possible exercise of market power i n forest product input and output markets has been long recognized. A recurring issue i n B r i t i s h C o l u m b i a has been the prices pa id by loca l pu lp m i l l s for w o o d chips used to produce pulp. T h e provincia l government has directly and indirect ly regulated the pulp fibre market i n the Interior o f the province both during its incept ion and throughout m u c h o f the past forty years. Government intervention l ed to a non-competi t ive outcome marked by l o w prices for w o o d chips that were characterized by the fact that prices pa id to suppliers were invariant w i t h respect to distance. A mode l shows how this particular equ i l ib r ium was inherently unstable, as evidenced by prices increasing four-fold after a change i n firm behaviour. Because the province owns o f most o f the forest land i n the province i t has developed a set o f goals concerning the provinc ia l forest industry that include prov id ing employment , maintaining communi ty stability, and col lect ing revenues f rom the harvest o f t imber on behalf of the publ ic . T h e provinc ia l government faces a series o f po l i cy questions regarding the forest industry i n terms o f harvest levels , regulation, trade p o l i c y , and stumpage design. I f past trends continue, pulp and paper m i l l s are l i k e l y to become the largest users o f the forest resource w i th in the next five years, whi le provinc ia l forest po l i cy remains focused on the product ion o f sol id w o o d products. A t the same time, increased fibre costs due to a combinat ion of government initiatives and decreasing fibre availabil i ty are affecting the entire forest industry i n B C . F o r pulp and paper m i l l s their fibre costs can 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 lows wi th in the sector as w e l l as the future structure o f the forest sector. Key Words: price d iscr iminat ion, pulp, w o o d chips, market power, B r i t i s h C o l u m b i a Table of Contents A B S T R A C T II T A B L E O F C O N T E N T S I l l L I S T O F T A B L E S V I L I S T O F F I G U R E S VII A C K N O W L E D G E M E N T S I X I N T R O D U C T I O N . . . . 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 C O L U M B I A I N T E R I O R 5 W H A T IS A W O O D CHIP? 5 D E V E L O P M E N T O F W O O D CHIPS AS A F I B R E S O U R C E 5 T H E F O R E S T INDUSTRY 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 D E V E L O P M E N T O F 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 23 T H E M O V E T O C L O S E U T I L I Z A T I O N S T A N D A R D S 2 5 T H E INTRODUCTION O F C H I P D I R E C T I O N P O L I C Y 2 8 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 2 9 T H E R O Y A L C O M M I S S I O N O N F O R E S T R E S O U R C E S 3 2 T H E F O R M A T I O N O F F I B R E C O E X P O R T INC 3 8 T H E F O R E S T A C T O F 1978 41 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 41 T H E G R A N T I N G O F V N E W ' P U L P W O O D A G R E E M E N T S 4 6 ' C H I P S H O C K ' 4 7 2. R E V I E W O F E C O N O M I C T H E O R Y 54 M A R K E T P O W E R A N D P R I C E DISCRIMINATION 5 4 M O D E L S O F P U L P W O O D M A R K E T S 5 8 M O D E L S O F S P A T I A L PRICING A N D M A R K E T P O W E R 6 0 D E L I V E R E D PRICING S Y S T E M S '. 6 8 F I R M B E H A V I O U R A N D T H E E F F E C T O N M A R K E T O U T C O M E S 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 7 4 STUDIES O F S P A T I A L PRICE DISCRIMINATION 81 S U M M A R Y : 8 2 3 . M O D E L I N G T H E I N T E R I O R W O O D C H I P M A R K E T . . . . 8 4 S U P P L Y O F S I N G L E A N D JOINT PRODUCTS 8 4 S O U R C E S O F H E T E R O G E N E I T Y IN W O O D CHIPS 8 5 E Q U I L I B R I U M W I T H JOINT PRODUCTION „ 8 6 INPUT PRICES U N D E R DIFFERENT SUPPLY C O N D I T I O N S 8 8 I N T E G R A T I N G D E M A N D A N D S U P P L Y 9 4 A M O D E L O F P R I C E DISCRIMINATION IN A W O O D C H I P M A R K E T 9 5 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 9 9 T H E I M P O R T A N C E O F PUNISHMENT P A T H S IN D E T E R M I N I N G N A S H EQUILIBRIA 121 4 . T E S T S O F P R I C E D I S C R I M I N A T I O N I N T H E W O O D C H I P M A R K E T I N T H E B R I T I S H C O L U M B I A I N T E R I O R 1 2 8 T E S T S O F M A R K E T P R I C E L E V E L S 128 T E S T I N G F O R C H A N G E S IN M A R K E T PRICE L E V E L S 134 R E S U L T S F R O M T E S T I N G F O R C H A N G E S IN P R I C E L E V E L S 135 T E S T S O F F I R M PRICES A N D PRICING P A T T E R N S 137 T E S T I N G F O R 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 P O W E R A N D F I R M R E A C T I O N S 145 E S T I M A T I N G R E S P O N S E F U N C T I O N S 146 E X A M I N I N G F I R M I N T E R A C T I O N 147 M O D E L I N G F I R M I N T E R A C T I O N 149 R E S U L T S F R O M E S T I M A T I N G F I R M I N T E R A C T I O N 150 S U M M A R Y 154 5. 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 . 1 6 1 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 P O L I C Y 167 S T U M P A G E P O L I C Y 169 T H E I N T E R A C T I O N 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 I N V E S T M E N T A N D E S T I M A T E S O F 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 Table 1. Br i t i sh C o l u m b i a Mature 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 Pu lp Produc t ion i n B C 12 T a b l e 3. Res idua l C h i p Produc t ion i n B C , by R e g i o n 13 Tab le 4. Expor ts of W o o d C h i p s f rom B C by R e g i o n for Selected Year s 13 Tab le 5. Estimates o f the P r imary B r e a k d o w n o f Harvest i n B C f rom 1990 to 1996 14 Tab le 6. A n n u a l Cut t ing Rights by C o m p a n y 17 Table 7. Interior Pu lp Capaci ty by M i l l and Loca t ion , Selected Years 21 Tab le 8. Est imated C h i p Recovery Factors i n the B C Interior 1987-95 9 0 Tab le 9. Cor re la t ion Be tween Product Pr ices and C h i p Recovery Proxies 93 Tab le 10. F i r m Payoffs Unde r Different P r i c i n g Strategies 110 Tab le 11. Potential Ga ins f rom D e v i a t i o n 130 T a b l e 12. M a r g i n as a Func t ion o f D e m a n d and M a r k e t P o w e r 136 Tab le 13. Es t imat ing W o o d C h i p Prices as a Func t ion o f Product Prices and Distance 141 Tab le 14. Reported Average C h i p Va lues i n the Northern Interior i n 1994 and 1996 144 Tab le 15. Pr ice Behav iou r Unde r A s s u m e d Pr ice Coord ina t ion 151 Table 16. Pr ice Behav iou r D u r i n g Revers ionary Per iod .152 Tab le 17. Estimates o f Rent and Charges O v e r Three Different Periods 176 Tab le 18. Estimates o f Rent and Charges on a per cubic metre B a s i s 177 Tab le 19. Return on Cap i t a l E m p l o y e d by Product 178 vi List of Figures Figure 1. Harvest by R e g i o n i n B C for Selected Years 11 Figure 2 . Interior Forest Product Pr ices Adjus ted for Inflat ion, 1970-1996 15 F igure 3 . Loca t ion o f P u l p M i l l s i n the B C Interior. 2 0 F igure 4 . P r i c i n g Unde r Competi t ive Condi t ions and U n d e r a M o n o p s o n y 56 Figure 5. Pr ice Discr iminat ion i n a W o o d C h i p Marke t 6 2 Figure 6. Increasing Pr ice Discr iminat ion as Demand Becomes M o r e Inelastic 6 5 F igure 7. Increased Compet i t ion f rom F i r m Entry Reduces Pr ice Discr iminat ion 6 5 Figure 8. Increased Compet i t ion f rom Over lapping Marke t Areas Increases Discr iminat ion 6 7 Figure 9. P r i c i n g w i t h and without Capacity Constraints 7 9 Figure 10. Supp ly C u r v e for Res idual C h i p s w i t h Reservation Pr ice B a s e d on L u m b e r Prices 9 2 Figure 11 . C h i p Recovery by Reg ion 1993-95 . 93 F igure 12. Marke t P o w e r i n a W o o d C h i p Marke t w i t h and without Discr iminatory P r i c i n g 9 2 Figure 13. S a w m i l l and Del ivered Pr ices for Different S a w m i l l s and P u l p M i l l s i n the Interior for the T h i r d Quarter o f 1989 9 7 Figure 14. S a w m i l l and Del ivered Pr ices for Different S a w m i l l s and P u l p M i l l s i n the Interior for the T h i r d Quarter o f 1990 98 Figure 15. G a m e Tree for F i r m s that Either C o m m i t to Pr ice U n i f o r m l y or Retain The i r Freedom to Pr ice Discriminate 104 F igure 16. B a s i n g Point P r i c i n g w i t h F i r m 1 the Pr ice Leade r . 105 F igure 17. Discr iminatory P r i c i n g by F i r m 1 and F i r m 2 112 F igure 18. U n i f o r m P r i c i n g by F i r m 1 and F i r m 2 113 vii Figure 20 . Ac tua l and Constructed Pr ice Series for W o o d C h i p s i n the B C Interior 127 F igure 2 1 . Relative Pr ice Changes i n Three W o o d C h i p Markets . 132 F igure 22 . Relative Change i n Pr ices and Produc t ion 1 9 8 7 - 1 9 % 133 F igure 2 3 . L u m b e r and C h i p Values per cubic metre o f L o g Input and Stumpage as Percentage o f L o g Values i n the Interior 170 F igure 24 . A n n u a l Rent i n B r i t i s h C o l u m b i a and T imbe r Charges i n 000 ' s o f Dol lars 176 viii Acknowledgements T h i s thesis w o u l d not have been possible without the support o f m y wi fe , 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 t imes interminable) process, as w e l l as her support. I w o u l d also l i ke to thank m y parents for their support throughout m y academic years. I w o u l d also l i ke to thank al l those people i n the industry and government officials who gave generously o f their t ime and shared their expertise. F i n a l l y , I w o u l d l i ke to dedicate this thesis to B a n n o c k . i \\ ix In t roduct ion T h i s thesis examines the development and structure o f the residual w o o d chip market i n the Interior o f B r i t i s h C o l u m b i a ( B C ) over the per iod 1961 to 1996. Since the incept ion o f the pulp and paper industry i n the Interior, wood chip prices wi th in the region have been a recurring issue that has received government attention. A number o f authors have noted that chip prices received by sawmil l s i n this region are thought to be \"too l o w \" or \"uncompetit ively l o w \" and have attributed these l o w prices to imperfectly competit ive markets. 1 T h i s issue warrants invest igation for several reasons. First , despite its l o w profile, the market is quite substantial i n size. Measured by the value o f shipments i n 1996, the Interior w o o d chip market exceeded the G D P of agriculture, f i sh ing and trapping, petroleum and natural gas, and coal i n B C ( B C Stats 1998). Despite the importance o f this market, i t is poor ly understood by those people w h o are not direct ly invo lved i n the industry, i n part due to a dearth o f publ ic information. T h e market is the largest w o o d fibre market w i th in the province (as w e l l as the largest regional market for pulp fibre i n Canada). V i r t u a l l y nonexistent forty years ago, the market today provides the bu lk o f the fibre for the fourteen pulp and paper m i l l s w i t h i n the region as w e l l as significant amounts to both the Coasta l industry as w e l l as the export market. It also serves as an important market for 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 . Second, the w o o d chip market provides an opportunity to examine how government intervention can frustrate normal market processes and lead to non-competi t ive outcomes. T h e w o o d ch ip market has faced at various times direct controls on prices, restrictions o n exports, and constraints o n where domestic volumes cou ld be sold. These pol ic ies have 1 See Mahood( 1990:195) and Bernsohn (1981:98), which make reference to l ow chip prices. A n Interior newspaper refers to chip prices less than half of those paid i n the B C Coast market (Cit izen 1974). In addition, Woodbridge (1984) and Ni l s son (1985) note that residual chips sell for substantially less than roundwood chips on the B C Coast and predict that residual chip 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 noticeably constraints o n l og exports. H o w these pol ic ies have influenced the development o f the w o o d chip market illustrates some o f the potential shortcomings o f government intervention. In addit ion, the issues invo lved i n the p r ic ing o f pulp fibre have long been a concern o f forest p o l i c y makers throughout Canada and other parts o f the wor ld . F i n a l l y , it has l ong been debated whether delivered pr ic ing systems (formulas that exp l ic i t ly calculate prices based on the geographic locat ion o f the producer or customer) facilitate or hinder competi t ion. In this case, a detailed data set on ind iv idua l f i r m prices and a relat ively static industry structure can shed l ight o n the issues i nvo lved i n such systems and show that, based on the evidence f rom this market, del ivered p r ic ing systems do facilitate col lus ive outcomes through permitt ing f i rms 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 chip market; • T o develop a model to examine the pr ic ing policies employed i n the wood ch ip market; and • T o investigate the p o l i c y consequences o f both market power and government intervention i n the Interior w o o d chip market. In terms o f methodology, the thesis w i l l : • review the development o f the w o o d chip market i n the B C Interior, inc lud ing specific pol ic ies geared towards the w o o d chip market; • review the economic literature regarding pulp fibre markets and market power, concentrating on price discrimination; • develop a mode l o f the Interior w o o d chip market and test it for evidence o f market power; and • discuss the results and the impl ica t ions for future publ ic po l i cy . T h e thesis relies on a large data set on w o o d chip prices col lected by the M i n i s t r y o f Forests w h i c h surveys w o o d chip prices i n the B C Interior as part o f the stumpage appraisal process. It was supplemented by additional information col lected i n a series o f interviews w i t h company executives after access to the provinc ia l data base was terminated. T h e primary data set is l imi ted to transactions between independent sawmi l l s and p l y w o o d m i l l s and pulp mi l l s . Information on the identity o f purchasers was discontinued i n early 1995 due to a change i n government po l i cy . T h i s required the col lec t ion o f information on prices f rom company executives directly, and as a result, the data col lected covers a smaller set o f purchasers through the first two months o f 1996 (wh ich covers the market peak). T h e data set on prices is also supplemented by addit ional data f rom other sources on prices i n other markets as w e l l as relevant production statistics. T h e thesis provides an extensive description o f market power i n the form of price discr iminat ion, w h i c h occurs when different customers (suppliers) pay (receive) different prices for the same good, after a l l adjustments for any differences i n the good, such as quality or transportation costs, have been taken into account. T h e thesis focuses on a particular type o f price discrimination that falls i n the general category o f delivered pricing systems. These pr ic ing systems are characterized by prices that are determined by some geographic formula; for example, a customer's price may be determined as the price o f a good del ivered f rom a specified point under basing point p r i c ing (e.g. \"Pit tsburgh plus\") , even i f the good does not come f rom that locat ion. Economis ts have long debated, w i th inconclus ive results, whether such systems reflect competi t ive or col lus ive behaviour. T h e thesis shows that i n this case, the particular del ivered pr ic ing system employed i n the B C Interior w o o d chip market cannot be explained by models of competi t ive behaviour. Rather, the pr ic ing system reflects a non-competit ive outcome that was sustained through tacitly collusive behaviour unti l very recently. In general, i t appears that delivered pr ic ing systems can hinder competi t ion through reducing uncertainty about firm-specific prices through the use o f c o m m o n price-setting formulae by a l l rivals and enabling f i rms to coordinate prices. T h e thesis concludes wi th an examination o f the consequences o f government regulation and intervention i n the development o f the w o o d ch ip market. It also discusses some o f the issues that arise i n the pulp fibre market that need to be taken into consideration i n developing future forest po l i cy 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 chips are produced by the breakdown o f slabs and other pieces o f so l id wood that are produced during the manufacture o f lumber . 2 These pieces are fed into a chipper that turns the irregularly sized pieces into smaller, more uniform pieces o f w o o d approximately the size o f a matchbook cal led w o o d chips. Depending on the nature o f the s a w m i l l , these chips can be directly conveyed to wai t ing trucks, ra i l cars, barges, or put into storage bins or stockpiles outside, where they can be reloaded onto the appropriate vehicle for del ivery to customers (pulp and paper mi l l s ) . Because o f variations i n species and moisture content, w o o d chips are usual ly expressed i n terms of a standardized measurement based on weight. In the Interior of B r i t i s h C o l u m b i a , the most c o m m o n unit is the B o n e - D r y U n i t ( B D U ) , w h i c h is the vo lume o f w o o d chips that w i l l w e i g h 2400 pounds (1089 ki lograms) after i t has been oven-dried to a constant weight (B ie rmann 1996). W o o d chips can also be produced by ch ipp ing whole logs, using specia l ized equipment, or through the use o f smal l mobi le ch ipping machines on the logging site. W h o l e l o g chips are commonly referred to as \" roundwood\" chips, referring to the manufacturing process, compared to the chips produced as a co-product during the manufacture o f so l id w o o d products w h i c h are commonly cal led \"residual\" chips. Development of Wood Chips as a Fibre Source T h e use of w o o d chips by the pulp and paper industry was first pioneered i n the Pac i f ic Northwest i n Port Ange les . Pulp and paper mi l l s w i th in the region had or ig ina l ly re l ied on large o l d growth western hemlock (Tsuga heterophylla (Raf . ) Sarg.) to provide their raw material . T h i s bright w o o d was particularly w e l l suited to the prevai l ing sulfite pu lp ing process i n existence at that t ime. 2 For a typical cubic metre of solid wood input, an Interior sawmill w i l l produce approximately 250 board feet o f lumber or 50% of the log ; .15 B D U s of chips or 3 0 % of the log , wi th the remaining 20% sawdust and hog fuel (Kuan 1997). i 5 Sawmi l l s were only interested i n the higher value o ld growth Douglas- f i r (Pseudotsuga menziesii ( M i r b . ) F ranco var. menziesi i ) , and pulp and paper m i l l s cou ld acquire abundant quantities o f hemlock for little more than the cost o f haul ing logs out o f the bush. A s the valuable o ld growth stands on the W e s t Coast were logged, sawmil lers shifted into less accessible parts o f the region and started u t i l i z ing different species, inc lud ing western hemlock. Increasing competi t ion for hemlock logs led pulp and paper m i l l s to search for alternative fibre supplies. T h i s resulted i n the use o f residual w o o d waste (main ly w o o d chips) f r o m the sawmi l l s w i t h i n the Paci f ic Northwest (Washington, Oregon, and the B C Coast) as a source o f furnish starting i n the 1930s. T h i s was encouraged by the development o f the Kraf t pulp ing process, w h i c h provided a technology that cou ld easily accommodate the wide varieties o f species w i th in the region, and the Pac i f ic Northwest saw sulfite and groundwood m i l l s gradually replaced by Kraf t m i l l s . Abundant s awmi l l residue provided a cheap source o f fibre for the pulp and paper m i l l s and supplied a g rowing proport ion o f their furnish for m i l l s i n the U S Paci f ic Northwest , increasingly displacing the use o f pulp logs (Carrothers 1938). In the 1940s two new pulp m i l l s opened on V a n c o u v e r Island (the Bloede l m i l l at Port A l b e r n i and the Harmac m i l l i n Nana imo , both s t i l l operating today). T h e y were the first to ut i l ize w o o d chips wi th in B C ( W e l l b u r n 1996). B y the 1950s, then, w o o d chips had been proven as a technological ly feasible source o f f ibre . T h e development o f engineered w o o d products, such as Oriented Strand B o a r d ( O S B ) and M e d i u m Density Fibreboard ( M D F ) i n recent years, has increased the demand for w o o d chips and marginal w o o d fibre, leading pulp and paper m i l l s to again search for less costly alternative supplies o f f ibre. F o r example , some Interior pulp producers now use sawdust to manufacture short-fibred pulp, whi le others have either buil t plants or adapted some o f their processing capacity to use such hardwood species as cot tonwood (Populus balsamifera ssp. Trichocarpa (Torr . & G r a y ex H o o k ) Brayshaw) and aspen (Populus tremuloides M i c h x ) . 6 In 1996, residual fibre f rom sawmil l s made up sl ight ly less than 7 0 % o f a l l fibre consumed by pulp m i l l s i n Canada (excluding recycled pulp), up f rom sl ightly more than 4 0 % at the beginning o f 1980 ( C P P A 1996). W i t h i n the U n i t e d States, residual furnish makes up 4 1 % of a l l fibre consumed; w i th in the Pac i f i c Northwest , the proport ion is higher at 6 5 % ( A P A various years). W i t h i n the B C Interior, residual chips make up 8 4 % o f the fibre needs o f pulp and paper m i l l s (Nelson et a l . 1997). Such a heavy reliance on s a w m i l l residual chips has t ightly bound the two industries together more so than anywhere else i n Nor th A m e r i c a . Before embarking on a description o f the w o o d chip market, i t is helpful to understand the resource base that underlies the s awmi l l i ng and pulp and paper sector w i th in the province o f B C . The Forest Industry in British Columbia T h e R e s o u r c e T h e Province o f B r i t i s h C o l u m b i a ( B C ) covers 95.2 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 covered by trees and 46 m i l l i o n hectares are considered productive forest l and ( B C M O F 1994). There are two broad forest types i n B r i t i s h C o l u m b i a , w i th the d iv id ing l ine between the Coast and the Interior running down the midd le o f the Cascade range roughly parallel to the B C Coast, w i th Vancouver Island and the Queen Charlottes considered part o f the Coastal forest region. W h i l e both forest regions are dominated by softwoods, there are considerable differences i n the composi t ion o f species. T a b l e 1 shows the relative composi t ion i n terms o f species for standing t imber volumes for the different regions. The Coastal forest is dominated by western hemlock, S i tka spruce (Picea sitchensis (Bong . ) Carriere) , true firs or balsams (Abies amabilis ( D o u g l . E x L o u d . ) D o u g l . E x J . Forbes , 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 smaller stands o f Douglas-f i r ; trees also tend to be larger than i n the Interior due to the more temperate cl imate. In the Interior, spruces (Picea glauca (Moench) V o s s , Picea mariana ( M i l l . ) B S P , Picea engelmanni Par ry ex. 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 Enge lm. ) and subalpine fir (Abies lasiocarpa ( H o o k . ) Nutt . ) predominate, and the trees tend to be m u c h smaller. There are substantial regional variations wi th in the Interior, w i th Ponderosa pine (Pinus ponderosa D o u g l . E x P . & C . L a w s . ) present i n commercia l quantities i n the southern Interior, wh i l e the eastern part o f the Interior has commerc ia l quantities o f hemlock and cedar. Table 1. British Columbia Mature Standing Timber Volumes as of 1996 (mi l l ions of cubic metres) Species Coast Interior To ta l Province Spruce** 116 1,474 1,590 H e m l o c k * * 1,175 341 1,516 B a l s a m * * 411 859 1,270 Lodgepole P ine 26 1,481 1,507 Douglas F i r 134 284 418 Western R e d Cedar 296 98 3 9 4 Y e l l o w Cedar 112 * 112 R e d / Y e l l o w Cedar*** 261 15 276 L a r c h _ 29 2 9 Ponderosa Pine 10 10 Whi t e Pine 1 6 7 * 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) The topography is also varied. T h e Coast is rugged, w i th litt le or no publ ic road access, wh i l e m u c h o f the Interior has substantial areas o f ro l l i ng forest accessible by road. A g a i n , there are differences wi th in the Interior; the southern and eastern Interior are more rugged than the northern and central Interior, and the transportation infrastructure is 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 can be broken into four parts f o l l o w i n g the Standard Industrial Class i f ica t ion (S IC) used by Statistics Canada. T h e first two parts, Logging Industry ( S I C 04) and Forestry Services ( S I C 05), are concerned wi th t imber harvesting and management. T h e remaining two parts concern the users o f the logs generated: Wood Industries, w h i c h consists o f what are ca l led so l id w o o d producers w h o manufacture such goods as lumber , p l y w o o d , shakes and shingles, poles and posts, and remanufactured products ( S I C 25); and the Paper and Allied Industries, p roducing ma in ly market pulp , newsprint , g roundwood papers and other paper and paperboard products ( S I C 27). In terms o f the value o f shipments, the forest sector accounted for 57 .4% o f a l l manufacturing shipments i n B C i n 1995, exports o f lumber were $7.5 b i l l i o n , and exports o f a l l pulp and paper products were $8.2 b i l l i o n ( C O F I 1996). Pu lp and paper m i l l s i n the province receive most o f their fibre needs indirect ly f rom the sol id w o o d sector i n the fo rm o f residual w o o d chips produced during manufacturing; when these are taken into account fibre consumption between the two major industries, w o o d and pulp and paper, was nearly equal i n vo lume. In value-added terms, newsprint and pulp accounted for, on average, 2 8 % o f the value-added i n the forestry sector for the per iod 1983 to 1993, wh i l e lumber and p l y w o o d accounted for 3 7 % (Schwindt and Heaps 1996). There is some significant variat ion i n the pulp and paper industry between the two regions, reflecting differences i n the resource base and the development o f markets. F o r example, the avai labi l i ty o f western hemlock and its suitabili ty for newsprint, coupled wi th the tidewater locat ion o f Coastal pulp and paper m i l l s has led to the development o f more newsprint and other groundwood paper capacity relative to the Interior. In addit ion, the special ized lumber production o f different species (such as cedar and Douglas fir) on the Coast has permitted the development o f specialty pulps to a larger degree than i n the Interior, where most lumber product ion is S P F (Spruce-Pine-Fir) w i th the resulting chips a b lend o f different species. Interior pulp and paper m i l l s have also been nearly completely reliant on residual chips produced i n the Interior, wh i l e Coastal m i l l s have had to rely increasingly on a variety o f sources inc lud ing imported chips, chips f rom the Interior, and chips produced f rom roundwood. Government po l i cy , inc lud ing how stumpage charges are calculated, also differs between the two regions, i n terms o f what types o f pulp fibre are included i n the appraisal system and what type o f harvested material is required to be brought i n . In the past, nearly a l l o f the w o o d chips produced and consumed i n the Interior have been residual chips produced by sawmil l s , al though there has been an increasing use of roundwood chips i n recent years. T h e alternative for Interior sawmil l s to shipping w o o d chips to pulp and paper m i l l s i n the Interior is either to burn them or to put them into landfi l ls , both c o m m o n practices i n the past. In most cases, chips were burnt a long w i t h other residue i n \"beehive burners\". Envi ronmenta l considerations have caused a rapid escalation i n the costs associated w i t h landf i l l ing , and the p rov inc ia l government is i n the process o f prohibi t ing the burning o f w o o d waste throughout the region. Patterns of Resource Use in BC Before investigating the development o f the w o o d chip market, it is instructive to look at the patterns o f product ion and 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 production i n B C on the Coast and i n the Interior for selected years since 1950. It can be seen that whi le the harvest steadily increased i n both areas, peaking on the Coast i n 1987 and i n the Interior i n 1989, the overal l increase i n harvest levels has come main ly from the Interior. W h i l e harvest levels roughly doubled on the Coast , they increased ten-fo ld i n the Interior f rom 1950 to 1995. Figure 1 . Harvest by Region in BC for Selected Years 100 1950 1965 1973 1977 1980 1983 1986 1989 1992 1995 D Coast El Interior (Source: Ministry of Forests, various years) Th i s increase i n t imber production was accompanied by an increase i n pulp and paper product ion. Table 2 shows the production o f pulp (which may be further converted into paper or sold as pulp) and lumber i n the province over the past twenty five years. The product ion o f both has steadily grown, w i th pulp production peaking i n 1994, seven years after the peak i n lumber production. Table 2 . Lumber and Pulp Production in BC Y e a r 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 product ion o f residual w o o d chips by region for the past ten years. D u e to the nature o f the product ion process, residual ch ip product ion shows the same pattern as lumber production, peaking i n 1987. W h i l e overal l residual ch ip production levels have subsequently fal len, it can be seen that is ma in ly due to a decrease i n residual chip product ion on the Coast , wh i l e Interior residual chip product ion has remained relatively steady. Table 4 shows the export o f w o o d chips f rom the province, identified by their region o f o r ig in , over the study period. Expor ts f rom the Interior have ranged around 10% o f total product ion for the past decade, and include exports by F ibreco Expor t (an export agency for sawmi l l s i n the Interior), ind iv idua l sawmil l s , and pulp companies w i th in the region. W h i l e exports f rom the Interior have fa l len i n recent years, an increasing proportion o f shipments to F ibreco Expor t have been purchased by pulp m i l l s on the B C Coast. Table 3. Residual Chip Production in BC, by Region (in 000's of BDUs) Y e a r 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 BC by Region for Selected Years (BDUs) Y e a r 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 pulp ing capacity throughout B C has l ed to the growing use o f r o u n d w o o d chips , w i th most of product ion and consumption taking place on the Coast . A l t h o u g h product ion statistics do not separate roundwood f rom residual chip production, there are summary statistics available that provide some indicat ion o f the amount o f roundwood chips being produced. Table 5 shows estimates o f the fibre passing through pu lp m i l l w o o d rooms and ch ipp ing m i l l s over the past f ive years versus that going to other pr imary producers (who m a y also produce roundwood chips) . It can be seen that whi le the amount o f lumber processed at sawmi l l s fe l l s l ightly, the largest increase was i n the amount o f roundwood passing through ch ipp ing m i l l s . T h i s has reflected both a move into poorer quali ty stands, y i e ld ing a greater proport ion o f wood suitable for ch ipping , and the need to supplement dec l in ing quantities o f residual w o o d chips. Table 5. Estimates of the Primary Breakdown of Harvest in BC from 1990 to 1996 (in thousands of cubic metres) 1990 1991 1992 1993 1994 1995 1996 % change Sawmill 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 Total Actual Harvest 76,477 78,316 75,297 73,676 74,369 74,004 75,932 75,392 74,894 75,650 74,952 76,741 73,891 75,213 (Source: Economics and Trade, Ministry of Forests, unpublished data derived from Major Primary Timber Processors) Harvest levels f rom provinc ia l lands peaked i n the late 1980s (see Figure 1) and a series o f government initiatives could mean that harvest levels might fa l l 17% i n the future, w i th some areas facing even greater reductions (Price Waterhouse 1995). Consequent ly , both lumber and w o o d chip production levels are expected to drop i n the near future. S a w m i l l s wi th in the Interior have increasingly turned to import ing w o o d fibre f rom A l b e r t a and other provinces and increased purchases of w o o d f rom private lands wi th in the province to meet their f ibre needs during periods o f h igh demand. 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 A d j u s t e d f o r I n f l a t i o n 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 Stud (Dfltd) - • — SPF Lumber (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) Simons and Cor tex (1993) examined the historical prices o f lumber 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 chip prices on the Coast showed a downward trend o f 2% per year i n real terms f rom 1970 to 1993, wh i l e interior chip prices had not changed significantly i n real terms for the same time period, expressed as a percentage o f the pulp price. Figure 2 shows prices for both lumber, pulp , and interior w o o d chips i n real terms for the per iod 1970-96. A s can be seen, pu lp and lumber prices have shown strong cyc l i c a l behavior over this period, whi le the price o f interior chips has closely tracked pulp prices unt i l 1995 when both pulp and chip prices reached record levels , on ly to fa l l i n 1996. T h e prices reported are for N B S K pulp (Needle B leached Sof twood Kra f t pulp , S P F studs (2x4 lumber i n 8 foot lengths) and S P F lumber (2x4 lumber i n random lengths), a long wi th the price for Interior w o o d chips, and have a l l been deflated us ing the G D P deflator. Structure of the BC Interior Wood Chip Market In 1996 there were 136 sawmil l s i n the Interior w i th an annual capacity i n excess o f 2 m i l l i o n board feet. 3 O f these, 9 4 had an annual capacity o f over 24 m i l l i o n board feet per year. Those 94 accounted for 9 7 % of the total Interior lumber capacity o f 11 b i l l i o n board feet (as o f 1996). Approx ima te ly 5 1 % of this capacity is owned by independent sawmi l l s (that is , unaffiliated wi th a company producing pulp and paper). 4 ' 5 A l t h o u g h regional rights to t imber differ, integrated companies control sl ightly more than ha 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 imber l icense holders i n the province, w i t h companies possessing pulp and paper processing capacity shown i n b o l d type. There are currently 25 pulp m i l l s i n the province . 6 Fourteen o f the pulp m i l l s are located i n the Interior, w i t h two, Skeena Kraf t and Eurocan , on the Nor th Coast and nine o n the B C Coas t . 7 W i t h the exception o f two, Celgar and Harmac Pac i f ic , these pulp m i l l s are owned by companies that have either received cutting rights through sawmil ls owned or affiliated wi th the company or have received cutting rights di rect ly . 8 3 There are no reliable numbers on sawmills smaller than this. A s a measure of comparison, there are 88 sawmills on the B C Coast with an aggregate capacity of 4.3 b i l l ion board feet. 4 Slocan accounts for 10% of this capacity and is included as an independent, although they own nearly al l o f the pulp m i l l at Taylor . They had acquired half ownership of one o f the pulp mi l l s and sawmills at Mackenzie which they have subsequently sold to the other partner. Their sawmil l ing operations are widely distributed throughout the province and the bulk of their sales are made to non-affiliated pulp mi l l s . 5 These figures were derived from Major Primary Timber Processing Facilities in British Columbia 1995 issued by the B C Minis t ry of Forests. 6 The pulp m i l l at G o l d River was closed in 1998 and efforts to re-open it have so far failed. 7 Both Skeena and Eurocan rely for a substantial portion o f their pulp fibre needs on residual wood chips from the Interior and consequently are considered part of the Interior market. 8 Celgar f i led for bankruptcy i n July, 1998, while Harmac was acquired by Pope & Talbot, a company with sawmills in the Southern Interior, in December 1997. In addition, M a c M i l l a n Bloedel spun off its two remaining pulp mil ls on the B C Coast in June, 1998, but retains obligations to supply fibre to those mil ls . 1 6 Table 6. Annual Public Cutting Rights in BC in 1997 by Company (in cubic metres)* C o m p a n y License V o l u m e s 3 % of A A C Cumula t ive Percent Slocan Forest Products 6,797,383 9.6 9.6 MacMillan Bloedel\" 5,917,561 8.4 17.9 Canadian Forest Products0 4 ,810 ,040 6.8 24 .7 West Fraser Mills 4 ,204 ,134 5.9 3 0 . 7 International Forest Products ' 1 3 ,514 ,152 5.0 35 .6 Noranda Forest Inc. 3 ,441 ,398 4 .9 4 0 . 5 Doman Industries 2 ,427 ,140 3.4 4 3 . 9 Skeena Cellulose 2 ,337 ,549 3.3 4 7 . 2 Rivers ide Forest Products ' 1 2 ,306 ,776 3.3 5 0 . 5 Weldwood 2 ,099 ,109 3 .0 53 .4 Weyerhaeuser 1,672,813 2.4 55 .8 Avenor 1,658,558 2.3 58.1 T o l k o 1,547,914 2.2 60 .3 Timberwest Forest* 1,445,280 2.0 62 .3 Anderson/Stewart Group 1,387,740 2.0 64.3 A i n s w o r t h L u m b e r 1,349,034 1.9 66 .2 Crestbrook Forest 1,220,095 1.7 67 .9 Industries Pope & Talbot 1,175,137 1.7 69 .6 Louisiana-Pacific Canada 904 ,000 1.3 7 0 . 9 Evans Forest Products 630 ,898 0.9 71 .8 A l l o w a b l e A n n u a l Cu t ( A A C ) 70 ,864 ,250 A A C H e l d by Companies w i t h 38 ,935 ,060 54 .9% o f A A C Pu lp and Paper Interest \"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. 0 Canadian Forest Products holds 1/3 interest in the Anderson/Stewart group that is not included in this volume. d These firms have evergreen contracts dedicating significant portions of their pulp fibre production to pulp 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 pulp mi l l s , w i t h the exception o f the Lou i s i ana Paci f ic pulp m i l l i n C h e t w y n d , the Scott Paper m i l l i n N e w Westminster , and the Newstech 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 port ion o f their furnish or as their complete source. In 1995, independent sawmi l l s i n the Interior provided 4 2 % o f the residual w o o d chips consumed by Interior pulp m i l l s (although there was substantial regional variat ion) 9 . 9 Th is figure is based on background data from Nelson (1997). Concentration wi th in regional fibre markets is quite h igh (these regional markets correspond to the s ix forest regions the province uses i n managing prov inc ia l forests). Throughout 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 Regions) , one pulp m i l l w i l l purchase the majority o f the fibre produced wi th in the region. W h i l e smal l volumes o f chips may be exported, shipments are capped and require government approval every few years. W i t h i n the K a m l o o p s area, the p rox imi ty o f the Coast and higher production levels relative to the capacity o f the Weyerhaeuser pulp m i l l mean that significant volumes o f chips are shipped into the Coastal market (Gaston et a l . 1995). In the Northern Interior (100 M i l e House and the area to the north), the closer p roximi ty o f pulp m i l l s to one another usually means two or more purchasers w i t h i n loca l markets. Despite this p rox imi ty , sawmi l l s i n the past tended to sel l to on ly one purchaser. M o s t exports f rom the Interior were made through a cooperative owned by sawmi l l s throughout the Interior cal led Fibreco Expor t . T h e cooperative placed various constraints on the price members could receive and the volumes that cou ld be shipped (Fibreco Expor t is discussed later i n this chapter). F ibreco export volumes are also subject to overal l restrictions and the need to obtain government approval for exports every few years. Pulping Processes B r o a d l y speaking, there are two m a i n ways to produce pulp f rom w o o d fibre. One is through strictly mechanical means to separate the w o o d fibres (sometimes termed refiner pulp) and the other is through chemica l processes such as sulfite pu lp ing or sulfate pu lp ing (referring to the predominant chemical present during pulping). In addit ion, recent years have seen the development o f some hybr id processes such as chemi-thermomechanical pulp ( C T M P ) that use both mechanical and chemical processes. The fibre requirements differ for the va ry ing processes. M e c h a n i c a l pulps require naturally bright woods, western hemlock and spruce being the preferred species. W h i l e kraft pulping can accommodate a greater variety o f species than mechanical pulp ing , bright woods are also desirable as they reduce the need for chemical bleaching. T h e major difference between the two processes, however, is that mechanical processes require roughly ha 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 pulp mi l l s i n the Interior use the bleached kraft process wh i l e the m i l l s bui l t since 1980 at Quesnel , Tay lo r , and Che twynd rely on either the thermo-mechanical ( T M P ) or the chemi-thermomechanical pulp ( C T M P ) process. The most recent m i l l bui l t , Lou i s iana Paci f ic i n Che twynd , uses aspen, w h i l e the T a y l o r m i l l has the capacity to use aspen. Some sawdust pulp capacity exists at both the K a m l o o p s and K i t i m a t m i l l s , whi le Fletcher Chal lenge has recently installed a sawdust digester at its Mackenz i e m i l l . The bulk o f the capacity is i n chemica l pulp using residual softwood chips. F i g u r e 3 shows the locat ion of pulp 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 cal led the Interior market. T a b l e 7 shows the development o f pu lp ing capacity i n the Interior over the per iod 1988-1998 as w e l l as the type o f capacity. Capaci ty has remained relatively unchanged over this t ime frame, w i th the exception o f the expansion o f the Celgar m i l l i n the southeast corner o f the province. T h e pulp and paper industry i n B C produces ma in ly pulp and newsprint, w i th some specialty groundwood papers. In the Interior, w i t h the except ion o f the F i n l a y m i l l , w h i c h produces newsprint exc lus ive ly , and Pr ince George P u l p & Paper w h i c h a long wi th Eurocan produces sack kraft and l inerboard, the m a i n product for the remaining pulp 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 2 0 paper mi l l s is market pulp ( L o c k w o o d Post directory, 1995).1 0 Marke t pulp is defined as pulp sold i n arms' length transactions between non-affiliated companies (as opposed to pulp consumed by a paper m i l l affiliated wi th the pulp m i l l ) . W h i l e B C has 27% of the Canadian pulp and paper capacity, s l ightly behind Quebec w i t h 31%, B C is the largest producer o f market pulp i n Canada w i t h 49.4% o f the Canadian market pulp capacity. Canada i tself is the largest producer o f market pulp i n the w o r l d and has 27% o f w o r l d capaci ty ( A n o n y m o u s , 1994). Table 7. Interior Pulp Capacity by M i l l and Location, Selected Years M i l l Loca t ion 1988 1990 1993 1995 1998 Weyerhaeuser Kamloops 426 431 440 431 447 Celgar Castlegar 193 183 414 396 414 Crestbrook Skookumchuck 185 181 181 219 224 Total Southern Interior Capacity 804 795 1,035 1,046 1,085 Quesnel R i v e r P u l p 8 Quesnel 300 311 328 302 314 Car iboo Quesnel 276 276 328 311 323 Intercontinental Prince George 235 236 236 258 (c) P G Pu lp & Paper Prince George 270 274 276 273 528 N o r t h w o o d Prince George 502 569 500 518 518 Fletcher Mackenzie 207 207 207 207 207 F i n l a y 3 Mackenzie 138 138 138 180 190 Fib reco 3 Taylor 207 180 177 212 231 Louis iana P a c i f i c 3 b Chetwynd - - 155 155 173 Skeena Cel lu lose Prince Rupert 431 483 466 449 449 Eurocan Kitimat 374 409 355 452 455 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 a CTMP/TMP process b mill using 100% hardwood c mill capacity included in PG.Pulp & Paper capacity . (Source: Economics and Trade, Ministry of Forests, Victoria unpublished data) In summary, the Interior w o o d chip market has been fai r ly stable i n terms o f production levels and regional demand (as measured by capacity). Concentrat ion tends to be h igh because markets for chips are geographically constrained and there is only a smal l number o f purchasers (often only one) w i th in most loca l markets. In order to sell into the export 1 0 Accord ing to the C P P A (1996), total industry capacity in B C for market pulp, paper, and paperboard was 8.3 mi l l i on tonnes, of which 5.2 mi l l ion tonnes were i n market pulp, or 6 3 % of the total. 21 market, provinc ia l government approval is required and volumes tend to be smal l and of l imi ted duration. The s imilar i ty o f end products and prevalence o f the same species means that most o f the w o o d chips produced wi th in the Interior are potentially interchangeable, and f i rms i n the region do engage i n chip swaps (trading fibre f rom different suppliers to either meet species requirements or to reduce transportation costs). Howeve r , i n the past, most sawmi l l s supplied on ly one pulp m i l l , and these supply patterns had remained relatively unchanged since the development o f the Interior market i n the 1950s (Ne l son et a l . 1994). T h i s pattern changed i n 1994, and to understand why , i t is necessary to examine the development o f the Interior market. Historical Development of the Interior Pulp Industry T h e development of the pulp and paper industry i n the B C Interior reflects the provincia l government 's traditional approach to forest po l i cy based on the al location o f tenure and fibre to encourage industrial development outside the lower main land area. However , as part o f this strategy, the P rov ince has also had to address concerns over market power and fibre supply. T h i s section w i l l show how both the market and government po l icy have evolved i n some unexpected w a y s . Ini t ia l ly , the market for Interior w o o d chips was l imi ted to smal l shipments to pulp m i l l s outside the region. 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 smal l , and most o f the w o o d fibre produced was i n the f o r m of slabs and l i l y pads ( l i l y pads were the disks o f w o o d s l iced off the ends o f logs). A n y residual chips produced were either burned or put into landfi l ls a long wi th other waste w o o d , al though there were some shipments o f chips f r o m those sawmi l l s i n the southern Interior nearest to Coastal pu lpmi l l s . D u e to concerns about the amount o f waste left behind (some estimates suggested that 7 5 % of the tree was left behind i n the woods)(Garner 1991), the government commiss ioned a study i n the early 1960s to examine the feasibil i ty o f a pulp m i l l i n the Pr ince George area to ut i l ize the marginal w o o d left behind. T h e findings o f the report 22 l ed R a y W i l l i s t o n , then Min i s t e r o f Forests, to develop a set o f pol ic ies to encourage companies to establish pulp and paper m i l l s i n the Interior (Garner 1991). The Development of Pulpwood Harvesting Agreements G i v e n the concerns over the size o f the capital investment required to construct a world-competi t ive pulp m i l l (approximately $50 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 mi l l s bui l t w o u l d have an assured fibre supply through a new type o f forest tenure ca l led P u l p w o o d Harvest ing Agreements ( P H A ) . These were introduced under amendments to the Forest A c t i n 1961 (Br i t i sh C o l u m b i a 1961), and were or ig ina l ly restricted to the Interior . 1 1 A l t h o u g h this provis ion was later dropped for several years, there were never any P H A s issued for the Coast . The P H A s were for 21 years and required the successful applicant to b u i l d and operate a pulp m i l l o f a specified capacity. The agreements specified a certain area and a m a x i m u m volume that cou ld be harvested, and required the pulp m i l l s to purchase pu lpwood and w o o d residues f rom timber cut w i th in the pu lpwood area by exist ing tenure (quota) holders before they cou ld ut i l ize the agreement. 1 2 Those purchases were condi t ional o n the prices for the residue not exceeding the costs o f harvesting pulp w o o d for the pu lp m i l l . I f the p u l p m i l l was unable to purchase enough fibre at that price, the agreement conveyed the right to cut pu lpwood directly to make up any deficiency. T h e first pu lpwood agreement was awarded to Pr ince George P u l p & Paper i n 1963, fo l l owed by one to K a m l o o p s P u l p and Paper i n 1963, then N o r t h w o o d P u l p & Paper i n 1964, Ca r iboo P u l p and Paper i n 1965, and another one to Pr ince George P u l p & Paper i n 1 9 6 5 . 1 3 1 1 Section 17A, Forest A c t of 1978 (Brit ish Columbia 1978). 1 2 Clause number seven appears to have been related to the issue o f the potential conflict between sawmills and pulp mil ls for cutting rights. Pearse, a chairman of a Roya l Commiss ion, queries Prince George Pulp on this: [Pearse]: \" N o w , my understanding is that or iginal ly, in 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 Minis ter . \" [Gunther]: \"Yes , that was a condition in clause 7,1 believe, o f the original P . H . A . agreement.\"(Pearse 1976a: 701) In P . H . A . no. 2, clause 7b required the pulp m i l l to purchase pulpwood generated i n the course of harvesting a stand i f offered to the company before they could utilize the agreement. However , these clauses as they relate to pulpwood appear to have been modified or dropped entirely subsequently [this clause as it related to P . H . A . 1 was dropped in 1972 when the commitment to purchase residual chips was incorporated](Pearse 1976a: 701) 23 However , not a l l the pulp m i l l s bui 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 Ce l lu lose (now Celgar) at Castlegar i n the Southern Interior i n 1961, w h i c h received its cutting rights through an adjacent s awmi l l i n the fo rm of a Tree F a r m License ( T F L ) . The two pulp and paper m i l l s on the Nor th Coast (considered part o f the Interior market) also received cutting rights through T F L s . Skeena Cel lu lose opened a second Kraf t pulp m i l l i n 1967 i n Pr ince Rupert. T h e or iginal owner, C o l u m b i a Cel lu lose , had opened a sulfite pulp m i l l there i n 1951 w h i c h was later converted to Kraf t i n 1980. Eurocan opened a pulp m i l l i n 1970 at K i t i m a t (a jo in t partnership between Wes t Fraser and a F i n n i s h company , E n s o - G u t h e i z t ) . 1 4 Crestbrook Forest Industries also buil t a pu lpmi l l i n 1969 at Skookumchuck , i n the Southeast corner o f the province , but d i d not receive a P H A . Crestbrook received an assured supply o f fibre through their m i l l l icense w h i c h directed sawmil l s i n the area to send them their residual chips (this is discussed more ful ly i n the section entitled Introduction of Chip Direction Policy).15 The other exceptions have been the two integrated s awmi l l and pu lpmi l l operations at Mackenz i e , each o f w h i c h received harvesting rights for the sawmil l s and were envisaged as stand alone operations. M a n y o f the companies that buil t pu lpmi 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 had pre-exis t ing sawmil ls i n the area. Others were jo in t ventures between loca l sawmi l l s and outside interests, such as K a m l o o p s P u l p and Paper (subsequently acquired by Weyerhaeuser) and Crestbrook, wh i l e Canadian Forest Products buil t a s a w m i l l at Pr ince George after receiving its P H A . T h i s ensured that a por t ion o f their supply was met by w o o d chips f rom their o w n facil i t ies. A t the same time the B C government had been studying the feasibili ty o f establishing pulp m i l l s i n the Interior, a new type o f s awmi l l ca l led the C h i p N ' S a w had been developed ( K e a y s , 1979). 1 3 Several other P H A s were awarded but the pulp mil ls were never built and the agreements lapsed. 1 4 Celgar received T F L 23, which was the only Interior T F L issued appurtenant to a pulp m i l l . O n the North Coast, Eurocan received T F L 41 in 1966, while the two pulp mil ls in Prince Rupert had two T F L s (nos. 1 and 40), each dating from the establishment of a pulp line. T F L 1 contains an appurtenancy clause requiring the licensee to operate a pulp m i l l (Haley in litt. 1995). 1 5 M i l l licenses were required in the past by companies planning to bui ld or expand timber-processing capacity. 24 Preva i l ing designs at the t ime broke d o w n logs by sawing of f the sides, leaving behind slabs and various other pieces o f irregularly sized so l id w o o d w h i c h could then be fed into a chipper to be converted into w o o d chips. T h e C h i p N ' S a w , however , chipped of f the l o g faces w h i l e ho ld ing the l o g more f i rmly . T h i s permitted smaller logs to be processed more qu ick ly . Smal le r logs had presented a problem wi th the older design as they tended to wander when being sawed and s lowed d o w n production. Because more o f the standing t imber cou ld now be u t i l ized , i t now pa id to sort logs and to run batches o f s imi la r sizes through the C h i p N ' S a w . T h i s also reduced the need to change the sawing setup to accommodate variations i n l o g size required wi th the older designs. A s a consequence, the throughput o f logs cou ld be increased signif icantly, thereby rais ing lumber and chip p r o d u c t i o n . 1 6 The Move to Close Utilization Standards T h e B C government also undertook some specific pol ic ies affecting the supply o f timber wi th in the Interior. T h i s invo lved a change f rom an intermediate ut i l izat ion standard to a \"close u t i l iza t ion\" c standard i n the mid-1960s. T h i s standard required companies to harvest smaller trees than i n the past (as w e l l as taking more of the tree). 1 7 Operators cou ld receive additional t imber rights (or quota) by demonstrating that they had the equipment to process smaller t imber and could produce chips to sell to a pulp m i l l . Because the increase i n harvest levels by adapting close ut i l iza t ion standards cou ld not be ful ly absorbed by a l l the sawmil l s at the t ime, the additional unallocated w o o d was k n o w n as \" th i rd band w o o d \" . 1 8 App l ican t s d i d not have to b i d for the additional quota 'There are two reasons for the development of the chipping headrig [the machinery that first breaks down a log at the sawmill] . Conventional sawmill ing practice gave lumber - the primary product, plus slabs, edgings, trim and l i l y pads, which could be converted into chips, plus sawdust, for which there was no ready market. Generally the sawdust had to be disposed of, a practice which was a cost in itself, and which ran into increasingly heavy opposition for environmental reasons. It would be of obvious economic recovery advantage to reduce the sawdust, and possibly to improve lumber recovery. Once the chipping headrig had been developed (in the mid-1960's) , a powerful economic incentive developed for their widespread application. The value o f lumber was greater per volume of wood than the value of chips, but the small logs available i n many areas could not be processed profitably by conventional sawmil l ing equipment.\" (Keays 1979: 9-10) For example, the standard for trees in the Interior went from 11\" d.b.h. down to 7 \" d.b.h., wi th ut i l izat ion to a 4 \" top, whi le maximum permissible stump heights decreased f rom 18\" to 12\" (Bernsohn 1981: 84) The name third band came from the idea that i f you drew a rectangle for a l l the wood wi thin a Publ ic Sustained Y i e l d Uni t ( P S Y U s were the administrative unit used for allocating cutting rights at 25 but rather received i t through a T i m b e r Sale Harvest ing L icense ( T S H L ) . 1 9 B y the 1970s, the B C government was mandating the use o f close ut i l izat ion standards for a l l cutting areas. T o make this smaller w o o d even more attractive, the government f ixed the rate at 55 cents per 100 cubic feet. T h i s was be low the sawlog stumpage rate at the t i m e . 2 0 T h e al locat ion o f this addit ional volume had several effects o n the Interior s awmi l l industry. T h e first was the increased capital requirements for equipment such as debarkers and equipment that could process smaller t imber, as w e l l as the need to obtain a chip contract w i th a nearby pulp m i l l . 2 1 Smal ler s awmi l l operators started sel l ing out as they were unable to afford the required equipment and the overal l result was a significant decline i n the number o f Interior sawmil ls whi le average capacity steadily increased. In addi t ion, chip revenues had now started to become part of the s a w m i l l ' s revenue, and those without buyers for residual chips or the abi l i ty to produce chips found themselves at a g rowing disadvantage. T h e lumber industry responded qu ick ly as the B C government offered the possibi l i ty o f increasing the amount o f t imber a quota holder cou ld cut i f they m o v e d to close ut i l iza t ion standards. G r o w t h was aided i n part by b o o m i n g housing markets i n the U S . 2 2 T h e product ion o f w o o d chips was the time), roughly one third of the wood was currently being used at intermediate utilization standards. B y moving to close utilization standards, another third was available to the quota holders in the P S Y U who could process such timber. The remaining third of the rectangle, or the \"third band\", was then the difference between that now held by the quota holders i n the P S Y U and the increased harvest levels for the entire P S Y U coming from close utilization. (Bernsohn 1981: 83-85). 1 9 The forest service started issuing T S H L s in 1967 although there was no specific legislation or amendments that spelled out this new type of tenure. They 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 wi th longer terms, offering greater supply security. Most importantly, operators were no longer required to bid for their timber supply on an ongoing basis. However , T S H L holders were required to operate an appurtenant facil i ty capable of handling lumber down to close util ization standards and producing wood chips (Haley in litt. 1995). 2 0 These rates were set administratively and were subsequently dropped in 1972 when the N D P government came into power (Garner 1991). 2 1 Rees (1966) reports that as security for a barker (a min imum of $100,000) sawmills often had to show a chip contract with a pulp m i l l . Bernsohn (1981) reports that barkers and chippers cost about $215,000 at the time. 2 2 \"Obviously , at least a portion of the sawmill industry is working toward close utilization standards much sooner than Vic to r ia , and even pulp m i l l management, expected it wou ld . \" ( B C L 1966) 26 so great that many o f the pulp m i l l s bui l t i n the 1960s shut d o w n their w o o d rooms (these were facilities i n the pulp m i l l that chipped pulplogs) , whi le some o f the later ones d id not even construct w o o d rooms. 2 3 A t the same time, increasing pulp and paper capacity o n the Coast also sent more m i l l s into the Interior l ook ing for additional fibre, but h igh transportation costs l imi t ed the potential supply form the Interior . 2 4 A d a m Z i m m e r m a n , then president o f Nor thwood Pu lp at the t ime, described the evolut ion o f ch ip prices i n the Northern Interior when testifying before the Pearse commiss ion i n 1975: ...$3.85 was the cost [in 1966] i nc lud ing our capital and interest charges o f producing ch ips . . . [ i ] f one attributed no value to the w o o d going into the product. The original price was started off at around $6 or $7.00, as I reca l l , and qu i ck ly escalated to about nine dollars and a half, and i n m y judgment, there was real open competi t ion between the pulp m i l l ch ip buyers...That was i n the in i t ia l stage, and I think that was relat ively stable for perhaps a four or f ive year period, at w h i c h point it began to escalate, and as y o u point out, there were more buyers, the competi t ion became I guess more active, although I w o u l d say equally the volumes o f chips that y o u were dealing wi th , 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 period, or really less than that, the chip price went f rom 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 monopsomist ic [sic] or monopol is t ic circumstances w h i c h w o u l d preclude truly competitive prices f rom emerging? Z i m m e r m a n : ...I think i t was a truly competi t ive price i n the circumstances, the circumstances being that there were in i t ia l ly two buyers who were unrelated and i n competi t ion. The market was isolated to some extent, although the fringes — on the fringes i t was competi t ive. The W i l l i a m s L a k e area cou ld f low south, and I don ' t remember the dol lar l i m i t but that put a l imi t o n it. There was the alternative source [presumably referring to roundwood chips] , and then there was the question o f what real ly has become a f lood o f chips...the supply exceeded our expectations.. (Pearse 1976: 964, 966-7) 2 3 Chipped roundwood fel l from 341,000 B D U s (29% of total fibre consumed) in 1966 to 201,000 B D U s (6.5% of total fibre consumed) in 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 North Coast)(Interior Pulp Group, 1975). Coastal companies reporting that from one-third to three-quarters of the cost of an Interior chip was transportation and they would not pay more than price at which they could obtain Coastal chips. Reported prices i n the Interior were reported in the winter of 1966 to range from $5 to $12 per B D U at the sawmill (Rees 1966). 24 27 The Introduction of Chip Direction Policy T h e Interior pulp companies, w h i l e enjoying the increased production o f residual chips, became concerned over the increasing harvest coming f rom the move to a close ut i l izat ion standard by the sawmi l l s , as sawmi l l s were now processing w o o d that on ly a few years earlier had been considered pulp wood . In response to this concern R a y W i l l i s t o n , the Min i s t e r o f Forests, created the chip direction po l icy i n the m i d 1960s. It required any operator u t i l i z ing third band w o o d to offer its chips to the nearby pulp m i l l , w i th the quantities based on the amount o f fibre received through the move f rom intermediate to close ut i l izat ion as w e l l as the area under w h i c h i t had received rights.25 F o r the most part, chip direction meant that chips went to the same pulp m i l l that held the P H A i n wh ich a s a w m i l l was located, the Min i s t e r also required some sawmil l s f rom outside P H A s to send their chips to specified pulp mi l l s . F i n a l l y , the Min i s t e r also stated that i f there were insufficient supplies o f fibre even after chips were directed to pulp m i l l s , then the \" th i rd band\" vo lume w o u l d be wi thdrawn f rom the sawmil l s and granted to the pulp companies (Crestbrook 1976, Weyerhaeuser 1976). W h i l e Interior pulp m i l l s found they had plentiful supplies o f chips, they st i l l felt that the ' third-band' w o o d had been promised to them through their P H A s and despite chip direction they had lost some control over their fibre supply. O n e response was to purchase sawmi l l s for their harvesting rights.26 In other words, vert ical integration was being encouraged. \"Canadian Forest Products agreed to use as much sawmil l waste as was economically possible, and, l ike most other Interior pulp mil ls , it received an understanding from the government that the firm would have the exclusive right to purchase chips from other firms in the area covered by the Pu lpwood Harvesting Agreement.\" (Bernsohn, 1981: 98) \"Consequently, timber volume that had been made available to pulp mi l l s under P H A s was now allocated to sawmills under Th i rd Band Timber Sales. . .Although by-product chips largely replaced roundwood, pulp mil ls lost a degree of control over wood supplies. This promoted pulp companies to become involved in sawmil l ing in order to get an assured supply of at least some of the residual chips .\" (Interior Pu lp Industry 1975) 28 T h e chip direct ion po l i cy was most often expressed as a condi t ion o f the cutting l icense, and was not formal ly 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 ty ing residual chip prices to kraft pulp prices. Previous ly , prices had been f ixed for an extended per iod o f t ime (Weyerhaeuser, 1975). B y 1972, Pr ince George Pu lp & Paper had also moved to a p r i c ing system relating the price o f chips to the m i l l net price o f p u l p . 2 8 T h i s practice of formula pricing, where the price pa id for w o o d chips is based on a specified percentage o f the pulp price, was widespread throughout the Interior pulp and paper industry by the early 1980s (Hay-Roe 1983). The Introduction of Minimum Chip Pricing and Export Restrictions T h e plentiful supply o f residual chips helped fuel an expansion o f the Interior pulp industry. The first signs o f trouble came when prices i n Nor th A m e r i c a n lumber markets dropped i n the early 1970s, shortly after ch ip direct ion had been introduced. A s sawmil l s shut down , pulp m i l l s , enjoying good market condit ions, increased the prices they were w i l l i n g to pay for chips to keep the sawmil l s going. T h i s co inc ided wi th the election o f the N D P government i n 1972. One o f the first issues the government started to examine was the issue o f chip prices. A c c o r d i n g to the Min i s t e r o f Forests, B o b W i l l i a m s , the province had: 2 7 A n example of chip direction is contained i n a letter dated March 4, 1970 signed by Ray Wi l l i s ton submitted by Inland Timber Management to the Pearse Commiss ion . \"Established licensees within the above noted Publ ic Sustained Y i e l d Units w i l l become eligible for additional cutting rights from 'third band' wood to be distributed on the basis of 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 with the holder of Pulpwood Harvesting Area N o . 2 [Kamloops Pulp & Paper] . . . A n y established licensee not prepared to abide by such conditions w i l l not be able to participate in any additional cutting right by reason of the distribution of 'third band' wood . Such licensees, however, would be required to operate to close util ization standards ... It is recognized that a fair price must be offered by the holder of Pulpwood Harvesting A r e a N o . 2 for such wood chips, sawdust and hog fuel, and I am confident that this w i l l be accomplished by individual negotiation.\" ( L J . M i l n e r 1975) Br ie f submitted by Prince George Pulp to the Roya l Commiss ion on Forest Resources, dated August 8, 1975, p. 17. 29 \". . .a pulp market that is extremely buoyant, very profitable and a s awmi l l industry that is pushed against the w a l l . . . the prices sawmi l l s are rece iv ing for their chips are by and large generally be low what they should be... M i l l s i n the Uni t ed States ... are getting four, f ive and s ix t imes what producers i n B C are getting.\" ( M a r t i n 1974). A t the same t ime, the B C government had commiss ioned a report to investigate what Coastal and Interior companies could afford to pay for w o o d chips as i t contemplated changing the stumpage system to incorporate the value o f w o o d chips. T h e first report were completed i n late 1973, and suggested that pulp m i l l s both on the Coast and i n the Interior cou ld pay more for their chips than they were currently p a y i n g . 2 9 T h i s led 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 long w i t h incorporat ing the price o f w o o d chips into the stumpage system. T h i s move was v i ewed w i t h skept ic ism by the industry w h i c h , al though company leaders had acknowledged.the p rob lem of ch ip prices, were not sure that government controls o n chip p r i c ing were necessary. Ian M a h o o d , then President o f the T r u c k Loggers Assoc ia t ion , said: \" . . . [w]e ...deplore the fact that i n the chip area i t is apparent that transfer p r i c ing is being advocated—taking some o f the profit f rom the pulp m i l l s and transferring i t to the sawmi l l s ... It is far better to have prices related to the costs o f product ion rather than have artif icial p r ic ing\" (Mar t in 1975). M a h o o d argued that the only reason the government may have had to get i nvo lved was due to its stumpage pol ic ies i n the Interior, and that when stumpage costs went up on the Coast the pulp companies voluntar i ly opened up their contracts w i th their chip suppliers and made adjustments. 3 0 T h i s d i d not happen i n the Interior as prices there were tied to escalation Given then current prices of $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 in the Interior were paying $15 delivered in the Interior ($20-$22 on the North Coast) and could afford at least $25 per B D U (Roberts and Sawadsky 1973, Alexander and Roberts 1973). Stumpage rates i n the Interior were derived from lumber values at the time, while stumpage rates on the Coast were determined by log values. 30 clauses relating to the price for pulp, and the Interior pulp m i l l s were wai t ing to see what the government was doing regarding stumpage ( M a r t i n 1975) . 3 1 Despite these concerns, the provinc ia l government proceeded wi th B i l l 171 and the power to establish m i n i m u m chip prices was set through the T i m b e r Products Stabi l izat ion A c t i n the F a l l o f 1974 (this p rovis ion st i l l exists i n Sect ion 148 under the Forest A c t ) . T h e price o f residual chips was set in i t i a l ly at $35 per B D U (Br i t i sh C o l u m b i a 1978) . 3 2 In addit ion, the A c t was used to br ing residual chips under export controls for the first t ime. T h e A c t also provided for the establishment o f a market ing board for w o o d chips, al though no such board was established at the t ime. F i n a l l y , the government simultaneously incorporated w o o d chip prices into the stumpage system for the Interior, using an administrat ively determined price that was lower than the m i n i m u m price set by the provinc ia l government. Ini t ial ly the mandated chip price led to higher revenues for s a w m i l l s . 3 3 H o w e v e r , the first signs o f a p rob lem soon showed up when pulp markets started to soften i n 1975, fo l l owed 3 1 The debate i n the legislature sheds some light on the perceptions of the market at this time. \" G . Gibson (L) : ... 'even assuming chip prices are raised substantially, [it] is only helpful to the independent operators so long as the government forgoes its habitual taking of something over 80 per cent of the increase in prices ... What is happening, really, is that is the government is finding another way to get revenue not out of the pulp mi l l s but out of the pulp mil ls 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 in this province ... I think most people on the floor o f this House agree that a higher price should be paid for Interior chips. There's that monopoly buyer's market in the Interior...There's just no question that it has to be fixed up. But 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.'\" Gibson goes on to suggest using the coastal market after adjusting for transportation, and notes that the governments estimates of chip prices coincide with then current prices on the Coast. ( B C Logg ing News 1975: 22-23) 3 2 After pulp prices increased i n the first part of 1974, the government commissioned another report on chip pricing in the Fal l of 1974, which stated that while here were some old contracts i n force with prices of $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 of 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 in the immediate short run Interior pulp mi l l s could afford to pay $60. \" . . . [M]any middle size operators found that their chip cheque was actually greater than their operating profit .\" ( B C Lumberman 1975) 31 by a strike at the Interior pulp mi l l s . W h e n the pulp m i l l s reopened after the provinc ia l government legislated the strikers back to work i n October 1975, the pulp m i l l s refused to take a l l the chips offered to them (Bernsohn 1981). There was no requirement to purchase a l l the chips produced by the sawmil l s , and chips started to p i le up. S a w m i l l s noted that at $35 a unit, pulp m i l l s were i n no hurry to purchase w o o d chips. In some cases, the growing chip piles meant that a s awmi l l had to shut d o w n as i t ran out o f storage room. One independent operator, A l Thor lakson , said \"these chip pi les are a monument to bureaucracy...the Stabi l izat ion A c t should be wi thdrawn and a more rational price for chips should be a l l owed to deve lop . \" 3 4 The Royal Commission on Forest Resources It was against this backdrop that a R o y a l C o m m i s s i o n , headed by Peter Pearse, was struck by the Province to investigate issues o f g rowing concentration i n the forest industry and the role o f economic incentives i n forest management. A s part o f its work , the C o m m i s s i o n also examined the issues o f m i n i m u m chip pr ic ing , chip direct ion po l icy , and chip export permits. Hearings were held throughout the Province . Near ly every major company wi th in the Province made a submission to the hearing and it is clear f rom many o f the submissions, f rom both pulp companies and sawmi l l s , that the supply and pr ic ing o f pulp fibre i n the Interior had become 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, ch ip pr ic ing was the major issue, and there was a consensus that chip direction had l ed to lower prices through reduced competi t ive pressures. Consider these passages f rom three entities that testified before the C o m m i s s i o n : \"The fo l lowing conditions affect chip market opportuni ty:-(a) C h i p direction as a condi t ion o f most tenures. (b) Freight rates and car supply avai labi l i ty on the Br i t i sh C o l u m b i a R a i l w a y seriously l i m i t additional del ivery points. (c) Expor t regulations effectively prohibit l ong term export. A producer o f chips connot [sic] contract to sell i n the export market for more than a few months, whereas domestic contracts cover periods o f up to ten years. T h e market opportunity on the basis o f a \"spot\" type export contract is obvious ly much less favorable than on a long term contract. 3 4 See Chapter 23 i n Bernsohn (1981) for a good description of these events. 32 In addit ion, \" p u l p l o g \" harvesting, close ut i l izat ion and ch ipp ing o f residuals is effectively mandatory for the s awmi l l industry. Under the above circumstances, the C L M A reluctantly concludes that chip price regulation, although abhorrent i n pr inciple , is inescapable i n practice.\" (Car iboo L u m b e r Manufacturers ' Assoc ia t ion 1975) \"Di rec t ion o f chips, restrictions on longer term exports and lack o f boxcars have severely aggravated an intolerable situation o f pulp ch ip over-supply i n the B C interior and poor economics i n sawmil l s . T h e r ig id nature o f the system of direct ion has forced the setting o f m i n i m u m pulp chip prices, as natural market forces were not a l lowed to work. W e expect that had these constraints not been on the system that chip prices w o u l d have fo l lowed the rise i n pulp prices m u c h more closely, and whi le prices i n some areas may not have reached $ 3 5 / B D U , ch ip 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 is a considerable volume o f tree material w h i c h is being burned at m i l l s or on logged sites or left to rot even when pulp m i l l s are operating. It is also apparent that some o f the material licensees are required to remove costs more to del iver and process through sawmi l l s than i t returns.\" (Rivers ide Forest Products 1975) The Interior pulp companies were concerned about what they felt had been the erosion i n their harvesting rights, and especial ly any further weakening o f the P H A s . \"It is evident f rom the foregoing that private contracts for the supply o f s awmi l l residual chips are an important part o f this f i rm ' s raw material security. F rank ly , the company w o u l d not have committed capital to the K a m l o o p s pu lpm i l l without these contracts. The extent to w h i c h they rested i n ch ip direct ion by the C r o w n was held to be a necessary part o f the arrangement.\" (Weyerhaeuser 1975) \"It is a l l very w e l l to imply.. . that the avai labi l i ty o f residual chips reinforced by the recently introduced \"ch ip direct ion\" po l i cy assures the pu lp m i l l s o f a supply o f raw material , but this is not i n fact the case. T h e sawmi l l s are not obligated to produce sufficient chips, and even i f they do, transportation or other difficult ies m a y prevent del ivery o f the chips to the pulp m i l l s . W e feel strongly that we must continue to have protection against the possibi l i ty o f f inding ourselves dependent on the vagaries o f the market for lumber products. T h i s is why w e consider the guarantees o f an independent supply o f w o o d contained i n our P H A Agreements to be the cornerstone o f our operations. . . A s a result o f the ' th i rd band ' po l i cy , w h i c h made available to the s a w m i l l industry the remaining annual al lowable cut resulting from the change f rom 'intermediate ut i l izat ion ' to 'c lose u t i l iza t ion ' , a potential conflict arose between the option granted to the pulp m i l l companies under their P H A agreements to harvest or to acquire up to a certain volume o f roundwood i f required and the cutting rights over the same w o o d granted to the sawmi l l s . \" (Prince George Pu lp and Paper and Intercontinental Pu lp 1975) \" S o o n after the first P H A agreement was signed, the government, apparently responding to pressure f rom sawmi l l ing 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, cou ld add to P rov inc i a l revenues one way or another, began promot ing the use o f this w o o d i n sawmi l l s . It appeared to reason that, i f enough sawmil l s cou ld be enticed into using the addit ional wood , there w o u l d be an ample 33 supply o f pulp chips available without resorting to ch ipp ing pu lpwood direct ly. T h e fal lacy o f this assumption is readily evident upon real iz ing that: a) although some w o o d is sound, i t is either too smal l to y i e l d marketable lumber or, i f sawn, it produces a preponderance o f single d imension material such as 2\"x4\" ' s w h i c h , when marketed i n large quantities, often suffers a fa l l i n market value to a price be low the cost o f manufacturing. b) some w o o d does not produce marketable lumber o f any grade and should not be processed i n sawmi l l s . Nor thwood agrees it was reasonable to a l low the exis t ing s a w m i l l i n g industry or any new sawmi l l s the rights to acquire unallocated wood , provided i t was generally wi th in the standards o f ut i l iza t ion i n force or developing at the t ime. However , the government not only allocated a l l the regular sized wood , but also the smal l and unmerchantable w o o d (for sawmil l ing) w h i c h i n most cases formed the basis for part o f the vo lume guarantees under the P H A agreement. A s matters stand today, sawmil l s compla in , w i t h considerable val id i ty , that m u c h o f the w o o d being forced on them by the close ut i l iza t ion po l icy is creating f inancial hardships. The government has moved to establish a base price for chips, w h i c h action helps to compensate for the shortcomings o f the close ut i l izat ion po l i cy but adds to the burden o f the pu lp m i l l s . . . \" (Nor thwood Pu lp 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 Nor thwood Pu lp and T imber , also pointed out that the introduction o f the chip direction po l i cy using P H A s had disproportionate effects: \" W h a t was real ly the problem there was our o x was being gored [referring to ch ip direct ion], i t was nice for some people but i t wasn ' t good for us, because we had a fu l ly commit ted P H A and we bought chips f rom outside our o w n P H A ...but then this thing [chip di rect ion] . . .el iminated our opportunity to acquire those chips, and I think to go back to your earlier point, probably impaired the market that existed, because there was no market. . . . i f we had been buy ing chips f rom someone i n P H A number one, those w o u l d , i n effect, be pre-empted by this provis ion , and the chips w o u l d log ica l ly then f low to Pr ince George P u l p . So i t was nice for them and nasty for us. (Pearse 1976a: 973-4) D a v i d Schine, president o f C a n y o n Creek Forest Products, a smal l s a w m i l l i n Valemount near the B C - A l b e r t a border, talked about the effect changes i n export po l i cy had on their exports to a pulp m i l l i n Alber ta . \". .over the years, our export permits were getting lesser t ime and I think they were d o w n to six months. A n d then f ina l ly i n 1973 i t was not renewed. A n d i t was suggested very strongly that we ship our chips to someone i n Pr ince George , w h i c h we d i d . \" (quoted i n Pearse 1976a: 657-8) T revor Jeanes, a registered forester w i t h B a l c o Industries (a f i r m w i t h sawmi l l s i n the southern Interior), responded to a question f rom D r . Pearse as to whether chip markets without regulatory constraints cou ld be competi t ive. H e said that: 34 \".. . there's been a s lump i n the pulp market. There perhaps is not a competi t ive situation exis t ing. P r io r to that, I bel ieve there was. . .Prior to d i rec t ion o f chips , we sold chips to the coast, to other pulp m i l l s that weren' t able to be used, or weren' t able to be taken f rom our m i l l by the plant l oca l ly . \" (quoted i n Pearse 1976a: 2842) M a r v i n Persson, manager for Federated C o - o p , a s a w m i l l i n the Southern Interior, described how the chip direction po l icy meant a l l their chips went to the pulp m i l l i n K a m l o o p s . \"..the direct ion is not there for the berth chips or for the T . F . L . chips [two area based forms o f tenure different f rom the P S Y U or vo lume based tenures through w h i c h the addit ional ' th i rd band ' w o o d had been issued]...the terms o f our contract says that we w i l l sell a l l chips manufactured i n our operations, to the Weyerhaeuser Canada company.\" (quoted i n Pearse 1976a: 3140) Pearse went on to conf i rm that it was the contract, not the tenure, that required them to offer a l l o f their chips to the pulp m i l l i n K a m l o o p s (Pearse 1976a: 3141) . F i n a l l y , B u d N e l s o n , forester for G a l l o w a y Lumber , a smal l s a w m i l l i n the southeastern corner o f the Province , answered a question f rom Commiss ione r Pearse regarding whether his chips were directed to Crestbrook, the nearby pulp m i l l . Commiss ioner : A r e y o u free to sell them somewhere else? Ne l son : N o , not really. A t certain times now y o u can sell chips i f y o u get the refusal o f the pulp m i l l , but generally, when they refuse so does everybody else.Paughter] (quoted i n Pearse 1976a: 3417) C r o w n Zel le rbach (now Fletcher Chal lenge) , w i t h sawmil l s i n the Interior and on the Coast , and pulp m i l l s on the Coast, provided a different perspective. T h e company noted that compet i t ion for supply contracts y ie lded the fu l l competi t ive price, as was the case on the Coast , and that \"as i n any landlocked region, there is an unavoidable degree o f regional imperfection i n the chip market. There is now on ly one buyer at K a m l o o p s . \" 3 5 T h e company felt that government intervention was unnecessary because the Coast offered a viable outlet for chips i n the K a m l o o p s area, depending on export po l i cy , transportation costs, and Coastal price levels . T h e company also stated that i f C r o w n Zellerbach 1976 35 there was to be any chip direction that it should be matched by a requirement to purchase directed volume. In his f inal report, Pearse (1976b: 301) provided a detailed description o f how the chip export system worked at that t ime. T o receive approval for a chip export permit, a cornmittee made up of Coastal buyers and producers determined whether the chips i n question were surplus to the needs o f Coastal pulp and paper mi l l s . A l s o attending was a representative o f the Interior buyers, w h o provided their op in ion on whether the applicant's chips were surplus to Interior requirements. I f the applicant received permission, the ch ip export permit was usually for a l imi ted two year period, and contained a notice o f need provis ion, w h i c h meant that either Interior or Coastal consumers could invoke the right to halt the export o f those chips and have them redirected to their m i l l . D r . Pearse felt that the difficulties i n obtaining permits and their short duration also l imi ted export opportunities and i n turn the producers' abili ty 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 chip producers. Pearse (1976b: 302) recommended that the ch ip direct ion po l i cy should be dropped (although the pulp m i l l to w h i c h the chips were currently directed should have a right o f first refusal) and that m i n i m u m chip pr ic ing should be exercised more selectively. Pearse suggested that a forest products board should be established to monitor chip prices and evaluate any structural impediments, such as inadequate transportation, that hampered the market ing o f chips. Pearse (1976b: 302) also recommended that the government drop the export tax on w o o d chips as w e l l as faci l i ta t ing the export o f w o o d chips. T h e N D P government cal led an election i n the winter of 1975 and lost to the Soc ia l Credi t Party w h i c h obtained a majority. In response to the ch ip surplus, the newly appointed M i n i s t e r o f Forests, T o m Waterland, 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 $30 per B D U . H e also announced that the government w o u l d proceed to use a formula where the price was based on nine per cent o f the average sel l ing price per short ton o f bleached Kraf t pulp for the preceding s ix month per iod. T h e price w o u l d be adjusted every s ix months and the ce i l ing o n freight costs borne by the pulp m i l l s w o u l d be raised to $14 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 ch ip surplus continued to grow i n the Interior, and the government pressed the industry to come up wi th a solution to the problem. Industry efforts to allocate the chips themselves had fai led and the government threatened to establish a forest products market ing board i n order to resolve the problem. In response, the pu lp and paper companies announced that they w o u l d once again attempt to deal w i t h the chip surplus . 3 6 In the meantime, the government asked H u g h Cooper , a retired lawyer , to try and come up w i t h a solut ion. Cooper 's answer, after evaluating possible alternatives for w o o d chips such as fuel or food for l ivestock, led h i m to conclude that their highest value lay i n m a k i n g pulp. A tour o f Europe and A s i a convinced h i m that sufficient demand existed overseas to warrant the development o f an export outlet for Interior w o o d chips ( 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 summer o f 1976 i t had become clear that the problem could not be solved internally, and that exports offered the most promise for handl ing excess c h i p s . 3 7 A l t h o u g h global pulp markets were poor, i t was felt that exports at least meant that sawmi l l s wouldn ' t have to burn their chips. Howeve r , pulp 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 pulp capacity. Estimates o f the surplus ranged f rom 5 % to 2 0 % , and the Deputy C h i e f Forester said t ry ing to get an exact 3 6 \"Waterland said he had set no time table for the industry to reach a solution: 'They (the pulp producers) can see what the problems are and I know they w i l l distribute the surpluses as evenly poss ib le ' \" . Vancouver Sun, Feb. 22, 1977. 3 7 \"Forest Minis ter T o m Waterland has had enough o f the bickering among the industry and has called a meeting for August 10 where he w i l l read the riot act for what well could be the final t ime .\" Vancouver Sun, August 3, 1977. figure was l ike \" t ry ing 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). Responding to the pulp and paper industry's concerns, the B C government stated that it d id not want to discourage the establishment o f pulp capacity i n the province. Therefore, the permits w o u l d be for f ive years and w o u l d be non-interruptible, w i th provis ions for renewal i n the fourth year (although renewal was not automatic). It was felt that this was the t ime per iod necessary to satisfy buyers' requirements for fibre (although they preferred 10 year permits) as w e l l as the lead-in t ime to bu i ld new pulp capacity i n the province ( B C L o g g i n g N e w s 1976c). In addit ion, the l i m i t on total exports was set at the lower end o f estimates o f the surplus. The Formation of Fibreco Export Inc. T h e difficulty i n obtaining indiv idual chip export permits led a group o f Interior sawmil ls i n 1977 to incorporate a company cal led F ibreco Expor t , l ed by Cooper . T h e pulp m i l l s continued to maintain their opposit ion to the idea o f chip exports, and argued that export ing w o o d chips was i n effect export ing jobs . Coope r accused the pulp m i l l s of deliberately rejecting the concept o f an independent exporter because i t w o u l d usurp their control over , the movement o f c h i p s . 3 8 B y 1978, however, the pulp and paper companies ' opposi t ion had softened as it became clear that they cou ld not consume al l the chips being produced by Interior s a w m i l l s . 3 9 In the meantime, the government announced that due to poor pulp market conditions it was lower ing the m i n i m u m price to $25 per B D U . Pu lp prices then were hover ing around $300 per tonne (see F i g u r e 2) (Vancouver Sun, December 24 , 1977). Discuss ions now shifted \"[Hugh] Cooper [chairman of Fibreco] accused the pulp mi l l s o f deliberately rejecting the concept of Fibreco because it would usurp their control over the movement of chips...Says Cooper bluntly: 'They (pulp mills) feel i t 's their God-given right to control the movement o f fibre in the province. They resent that there's an upstart organization that w i l l break that cont ro l . ' \" Vancouver Sun, August 3, 1977. ' \" W e have never resisted a reasonable outflow of chip (but) naturally any pulp company would get concerned i f there is a massive outflow, ' says M a r k Gunther, President of Prince George Pulp and Paper. ' A n d i f you take it to its ultimate conclusion you w i l l be exporting jobs . ' \" Vancouver Sun, August 3, 1977 38 to the length o f export contracts, w i t h independent sawmi l l s pushing for 15 years, and the pulp companies arguing for no more than f ive years (Vancouver Sun, M a r c h 8, 1978). H o w e v e r , accord ing to H u g h Cooper , by now C h a i r m a n o f F ib reco Expor t , opposi t ion to exports had st i l l not ceased, and Fibreco Expor t had to go outside the province to f ind the f inancing for the export faci l i ty that had to be buil t i n V a n c o u v e r . 4 0 Orig ina l ly consisting o f thirty independent s awmi l l companies scattered across the Interior, F ibreco was based on the concept o f a cooperative to use ind iv idua l chip contracts to come up wi th a poo l o f chips for the Japanese market. In order to make the consor t ium viable , the members agreed to poo l transportation costs so that each member w o u l d receive a c o m m o n net price by deducting the average transportation cost f rom the export price. A s part o f this arrangement, because some o f the chips were c o m i n g f rom great distances, Cooper arranged for some o f the Interior pulp m i l l s to take their chips f rom closer suppliers (i.e., ch ip swaps). F o r example , chips f rom For t N e l s o n went to M a c k e n z i e , on ly a th i rd as far as to the Coast. Cooper noted that i t was not very diff icult to get the pulp mi l l s to agree to this when he cou ld show them the cost savings (Cooper pers. c o m m . 1995). F ibreco shipped its first load o f chips September 2 9 , 1 9 7 9 . Coope r had been successful i n demonstrating that there was a substantial market for export chips wi th the strongest demand coming f rom the Pac i f ic R i m . H e signed a contract for 400,000 B D U s annually for ten years w i t h Japanese pulp m i l l s . T h e export faci l i ty was designed to handle up to a m a x i m u m of 750 ,000 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 long term; second, that supply w o u l d be steady and not subject to interruptions; and third, that there be a good tidewater handling faci l i ty . Cooper emphasized that the first condi t ion was extremely important. There was already a perception that B C was an Cooper attributed the problem to the fact that every local bank had a pulp and paper company officer sitting on the board which had final approval of al l loans. (Cooper 1995) unreliable source o f w o o d chips i n the export market, based on a series o f interruptions f rom the Coast to the U S market i n Puget Sound i n the late 1960s. 4 1 Cooper pointed out that the Interior pulp mi l l s were content to rely on just the residual chips that were an inevitable byproduct o f lumber production, and were fa i l ing to ut i l ize a l l o f the w o o d i n the forest (Hiba l le r , September 1979). Coope r also agreed that F ibreco ' s entry into the chip market cou ld raise prices i n the Interior and stated that B C ' s Interior pulp m i l l s had the lowest 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 of Fibreco Expor t appears to have coinc ided wi th the development o f a quarterly report entitled the R e g i o n 1 A u d i t Commit tee Report , issued by the C O F I C h i p Task Force formed at the same time. T h e or iginal report appears to have been drawn up i n an attempt to quantify the chip surplus i n the Interior, and split the province into three regions based on ch ip production and consumption: R e g i o n 1 covered the Nor thern Interior, inc lud ing the Nor th Coast; R e g i o n 2 covered the Southern Interior; wh i l e R e g i o n 3 covered the South Coast and Vancouve r Island. T h e usefulness o f this report appears to have l ed to its continuation on a quarterly basis, funded by the industry, and i t is currently circulated among pulp m i l l s w i th in the region. It appears that some Coastal consumers also receive copies 4 3 The report purports to cover a l l production, consumption, and inventory changes for a l l producers and consumers w i th in the region, w i th some information about exports outside the region (either to pulp m i l l s outside the region or to the export market). 4 1 Cooper (1981) stated that: \"it was found in the first foray into the international marketplace that it was long recognized by the international buyers of wood chips that Bri t ish Columbia was not the most reliable source of supply for wood chips. Over the years there had been a vacillating pol icy on the export of fibre from the province for various reasons: the vicissitudes of poli t ical and economic factors of changing governments and the lobbying pressures on governments by diss imilar i ly [sic] interested groups.\" 4 2 Export prices were U S $ 91.25 per B D U in the fall o f 1979 (Canadian Pu lp and Paper Industry, November 1979), while Interior prices were $32 per B D U (the min imum price) ( B C Lumberman, September, 1979). Coastal prices ranged between $60-$64, and Fibreco had obtained contracts for $56 per B D U (Globe and Mail, December 13, 1979). 4 3 This 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 new Forest A c t i n response to changes i n the forest industry and the recognit ion that t imber quotas had become a de facto f o rm of tenure (Br i t i sh C o l u m b i a 1978). P S Y U s were replaced by T i m b e r Supply Areas , and licensees were a l lowed to convert their T S L s and T S H L s into Forest L icenses ( F L s ) , v o l u m e based tenures w i t h fifteen year terms (Haley 1995). In terms o f the P H A s , the government had realized that sawmil ls had dramatically improved their abil i ty to use smal l diameter wood , m a k i n g the defini t ion o f pu lpwood even more ambiguous, and so had not issued any more pu lpwood harvesting agreements after the in i t ia l f lurry i n the 1960's. The A c t changed P H A s to P u l p w o o d Agreements ( P A s ) replaceable every 10 years wi th 2 5 year terms. 4 4 P u l p w o o d Agreements that were subsequently granted also differed f rom earlier P H A s by clearly specifying the w o o d that w o u l d be available under the license wi th the expectation that these licenses w o u l d be used for harvesting. T h i s was a substantial change f rom the earlier agreements, w h i c h had or ig ina l ly been envisaged as p rov id ing a backup source o f fibre (they had only been used to a l low harvesting i n one instance). E x i s t i n g P H A s were converted into P A ' s as their renewal terms came up, although the terms o f the agreement remained unchanged unti l recently. T h e fo l lowing year (1979) saw a dramatic drop i n the lumber market, w h i c h coupled w i t h higher stumpage rates, was p lac ing increasing pressure on sawmi l l s yet pu lp prices were r is ing. H u g h Coope r predicted that sawmil l s w o u l d close g iven current lumber and ch ip prices, w h i c h i n turn w o u l d dr ive up chip prices as logg ing was curtailed (the m i n i m u m price o f chips had now m o v e d up to $40 per B D U ) ( Vancouver Sun, December 14, 1979). Chip Direction Policy Dropped In 1980, the government issued a notice o f intent to award a new P A i n the W i l l i a m s L a k e area i n the Central Interior of the province. T h i s w o u l d be the first such agreement Section 17A , Forest A c t of 1978. awarded under the new Forest A c t , and it attracted a great deal o f interest. Three companies, N o r t h w o o d , Ca r iboo , and Quesnel R i v e r P u l p , appl ied for the w o o d , w h i l e several others made general submissions urging the government to consider the implicat ions o f awarding a new P A . The hearings themselves clearly identified chip direction as the major issue i n the Interior pulp fibre m a r k e t . 4 5 Ult imate ly the Min i s t e r of Forests decided not to award a pu lpwood ag reement 4 6 T h e minister, however, d id drop m i n i m u m chip pr ic ing , and replaced the ch ip direct ion po l i cy w i t h the right o f first refusal. T h i s right meant that the purchaser w h i c h had previously enjoyed the chips under chip direction had the right to meet the best offer f rom another purchaser before a s awmi l l cou ld sell to another pulp m i l l (although e l ig ible buyers were restricted to other Interior pulp mi l l s ) . T h e government also incorporated the fu l l value o f w o o d chips i n the stumpage system starting i n September, stating that the fu l l regional market price w o u l d be used (Province, M a r c h 9, 1980). 4 7 Independent sawmillers we lcomed the change, since they felt that removing these constraints w o u l d mean a market price more reflective o f supply and demand conditions. Some, however , had some concerns about the change i n stumpage p o l i c y . Some industry 4 5 Quesnel River Pulp (QRP) proposed to bui ld a T M P mi l l i n Quesnel. West Fraser, which owned several sawmills in the Northern Interior, had a fifty percent interest in Q R P and was in favor of dropping chip direction as West Fraser's chips that could go to their proposed m i l l were being directed elsewhere. Cariboo was in favor of continuing chip direction pol icy , since most of the chips they received were directed. Their chairman said \"The whole basis of the operation and the future revolves around that chip direction pol icy\" . Northwood stated that it was opposed to chip direction pol icy but couldn't r isk seeing its supply of 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 . , while Canfor stated that they relied on chip direction for their fibre needs. C r o w n Zellerbach urged the minister to reject al l 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 domino effect from chips being redirected. (Province of Br i t i sh Co lumbia 1981) 4 6 West Fraser, in a joint venture with Daishowa, proceeded to build a thermo-mechanical ( T M P ) pulp m i l l in Quesnel in the early 1980's despite the fact that they did not receive a P A . 4 7 ' T h e stumpage system in the Interior at the time was based on the Rothery method. After computing the end product values that a log could y ie ld , costs and an allowance for profit and risk were deducted to arrive at the appraised stumpage price. Chips were not originally included as an end product until 1973 and then they were valued at $2 per B D U , c l imbing to $10.50 by the end o f 1980 (at which time the min imum price was $35.15 per B D U ) . \" Province, March 9, 1980. 42 participants said that sawmil ls w o u l d receive less under the new system than under the exist ing system (it was calculated that o f the $10 used i n the stumpage appraisal, the s awmi l l kept $2), whi le others were concerned about what region w o u l d be used to determine the price. Sa id one sawmil ler : \" N o w that we have an export market, we're more or less on an equal foot ing wi th the pulp mills . . . they now have to come up wi th their price or we export\" (Vancouver Sun, M a r c h 8, 1980). H u g h Cooper , then chairman o f F ibreco , was a bi t more skeptical . W h e n asked whether the higher export prices w o u l d squeeze the Interior consumers, he thought i t un l ike ly as the Interior m i l l s , be ing the major consumers, w o u l d purposely ho ld their prices be low what F ibreco was offering (Province, M a r c h 9 ,1980) . T h i s v iewpoin t proved to be accurate: wh i l e export prices paid to F ibreco members increased to U S $99 per B D U for the next s ix months starting January 1 (Globe & Mail, Feb . 18, 1980), domestic ch ip prices remained unchanged. Cooper attributed this to the fact that the most l i k e l y buyers f rom outside the region were not permitted to b id for chips i n the region, and that pulp m i l l s i n the Interior saw no need to raise p r i ces . 4 8 Cooper talked about the possibi l i ty o f setting up ch ipp ing stations i n Pr ince George, Quesnel , and K a m l o o p s (Province, M a r c h 12, 1980) to meet the demand i n these other markets. \"Regulations dealing with wood chips i n the B C Interior took effect A p r i l 1 when Forests Minis ter Thomas Waterland removed the floor price - which had been 9 per cent o f the selling price of the pulp. He also removed a requirement that sawmills in certain areas had to sell their chips to designated pulp mil ls , holders of pulpwood harvesting area licenses. It was expected pulp mil ls needing chips would b id , pushing up the price, but M r . Cooper said this has not happened for two reasons. Pulp mil ls were granted first refusal of chips in their harvesting area and option to buy at the price agreed in the sale to 'others'. But the minister said only other Interior pulp mi l l s could get involved in this process, M r . Cooper said. This excludes export buyers, who are paying about $100 a unit, and B C coastal pulp mil ls , which are paying $91 to $93 a unit. Interior pulp mil ls , which formerly kept their chip price at a min imum by agreeing that nobody would pay more, are still doing the same thing despite a change in regulations, M r . Cooper said. C h i p prices are actually slightly lower than before, he said. Supply has been curtailed as sawmil l operators attempt to withhold their chips to get a higher price, but the boycott is not being completely maintained. The poor lumber market means 'everybody is scratching to pay his banker. They need the cash f l o w ' . A s a result, Fibreco, which pays twice the pulp mil ls ' price, ' is being deluged with chips, ' he said.\" Globe and Mail, A p r i l 9, 1980 43 T h e price o f lumber continued to drop. A t this point, i t was quite clear that w o o d chips and lumber were co-products: at l o w enough lumber prices, ch ip revenues determined whether a s a w m i l l stayed open . 4 9 M a r k Gunther, at Pr ince George Pu lp and Paper, argued that Interior pulp m i l l s provided long term markets for w o o d chips and could not be expected to pay the export price as i t reflected spot p r ices . 5 0 Gunther stated the answer was to tie ch ip prices to the price o f pulp (much as the m i n i m u m price had been determined), whi le H u g h Cooper responded by not ing that the pulp industry wor ldwide pa id at least one-third o f the sel l ing price o f pulp for their w o o d fibre. The Interior pulp m i l l s responded to that argument by saying that they faced higher transportation costs, w h i c h raised the cost o f fibre delivered to the mi l l s . Compla in ts about chip pr ic ing started to surface again on the Coast i n 1987 as the price o f pulp started to increase. 5 1 In December o f 1987, Canfor announced that they were 4 9 \"Few mil ls have closed so far, according to E . V . Scoffield, manager of the Northern D iv i s i on for COFI . . .The main impact of the ai l ing U S market is on independent sawmillers, which unlike the larger, integrated companies, do not have fat pulp and paper revenues to offset the lean times for lumber...Sales of the byproduct chips can add $30 to $50 a thousand board feet to revenue, i f they are sold for export. Sales of chips to Interior pulp mil ls would add only $20 to $25, because they have been holding the price down, 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 mil ler from sawing a thousand board feet o f studs would 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 sti l l an oversupply o f chips in the Interior... The Interior was set up by the government as a separate region for chips and it is a separate market,\" said Gordon Thomson, vice-president, Pulp, for Northwood Pulp and Timber L t d . of Prince George. ' I t is pointless to complain that prices there are not as high as elsewhere. We ' r e going to pay what the market requires.\" M r . Gunther [of Prince George Pulp and Paper] said it is government pol icy that chips should not be transported out of one region and that only chips that are surplus to domestic requirements may be exported. In his view, a surplus no longer exists. Globe and Mail, July 25, 1980 5 1 \"Un t i l recently, there was some negotiating involved i n setting chip prices and some variation i n the prices paid by the pulp producers. 'Th is time, there were no negotiations,' said Joe Frumento, vice-president of Doman. T h e majors said this is what we're paying and that's i t ' . . . Acco rd ing to M r . Frumento and other sawmill spokesmen, al l of the pulp companies have offered the same prices, $70 a unit in the case of hemlock. . .Asked why al l the major companies are offering the same prices for wood chips, M r . Dent [general manager of raw material services for Macmi l l an Bloedel] said: 'Companies are not going to pay more than other companies are paying...we do not sit down with other major buyers and decide what the price is going to be for the next quarter.' Accord ing to M i k e Thompson, manager of trading fibre supply for C r o w n Forest industries, prices as a percentage of the pulp price in 1981 were higher because supplies were tighter and mil ls were whole log chipping. He said that there was currently a surplus o f chips on the Coast. The 44 undertaking a major expansion o f their m i l l i n H o w e Sound. Peter Ben t l ey , the chairman, stated that the expansion was partly condit ional on chips currently being exported being re-directed to the pulp m i l l . 5 2 Independent sawmillers pointed out that curtai l ing exports w o u l d reduce the pressure i n the market and lower p r i c e s . 5 3 In 1987 the B C government adopted a new stumpage system i n response to an A m e r i c a n trade action launched against Canadian softwood lumber imports. T h e new system decoupled chip revenues f rom the stumpage system, using on ly lumber values to establish overal l stumpage levels , wh i l e chip prices were used to distribute the stumpage charges. 5 4 T h i s system was k n o w n as the Compara t ive 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 poor lumber prices, wh i l e pulp prices had recovered f rom their l ows i n the first part o f the decade. 5 5 Sawmi l l s renewed their complaints about the prices they were receiving for their w o o d chips and the M i n i s t e r o f Forests, D a v e Parker , took two steps. T h e first was to loosen export restrictions to make i t theoretically easier to grant permits, and the second was to ask independents also said that i f they could sell them in the U S they would get much more for their chips; however, they can only get two year permits, which is not long 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 of 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 Aspen Planers...on the export restrictions being sought: 'These companies, Canfor included, the ones that operate the pulp mi l l s , use these means to regulate the price o f chips. Curtai l ing chip export permits is going to give them a more closed, in-house, situation, which is what they want, so there w i l l always be a surplus of chips to keep chip prices as low as possible. ' . . .Tony Jarrett [ of Fibreco]: ' . . .Restricting chip exports would ensure Canfor has the opportunity for a cheap chip supply . . .And what's bad about that is Canfor wou ld be r iding on the backs of the non-integrated sawmil 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 of lumber as wel l as chip prices) and operating costs were then used to distribute charges across firms cutting public timber. Recent changes to the system lowered the level of timber charges, and chip revenues are once again being used i n determining the overall target revenue rate. 5 5 \"For many large, integrated forest product companies, the weak lumber market has been offset by rising prices for other commodities l ike newsprint and pulp that are used to make fine papers. But 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 Random Lengths survey of Bri t ish Columbia . That is a big change from the early 1980's, when U S sawmills were forced to close while their B C competitors, helped in part by low stumpage fees, kept producing even as the benchmark lumber price fel l below $130 a thousand board feet.\" Financial Times, Sept. 26, 1988 45 the pulp m i l l s i n the Northern Interior to voluntar i ly raise their chip price. In the Sp r ing o f 1988, Car iboo Pu lp and Paper announced it was voluntar i ly raising its price $9 to $75 per B D U , wh i l e the pu lp m i l l s i n Pr ince George took no action. A year later, concerned that sawmil l s may shut down , Parker again approached pulp m i l l s i n the Interior, threatening to invoke m i n i m u m chip pr ic ing unless they raised their prices (Financial Post 1989). A p p l e b y (1989) showed that although there was an overal l smal l surplus o f chips that went into the export market i n 1987, that surplus vanished wi th in two years i f planned expansions i n pulp capacity and reduction i n sawmi l l ing capacity were taken into account. The Granting of 'New' Pulpwood Agreements One o f the proposals the provinc ia l government decided to investigate i n 1990 was the possibi l i ty o f awarding pu lpwood i n the northwest area o f the Interior. A s had been the case i n 1980, nearly every company wi th in the region either applied for the pu lpwood license or intervened i n the hearings. S i x companies applied for the fibre for a variety o f uses. T w o different pulp and paper companies i n the region, Canfor and Quesnel R i v e r P u l p , wanted the fibre as a back-up source, whi le a consort ium o f sawmi l l s and A l c a n proposed to bu i ld a pulp m i l l i n Vanderhoof. One independent sawmil le r wanted a port ion o f the proposed area that lay near their exist ing cutting rights; and two other companies proposed to use the deciduous species for so l id w o o d products. N o r t h w o o d appl ied for intervenor status (along wi th many non-industry groups) to submit issues they felt that the minister should address i n terms o f access to fibre (Province o f B r i t i s h C o l u m b i a 1990). B y this t ime, the increase i n pulp capacity had grown to the point that g iven the anticipated increases announced and potential f a l ldown i n t imber supply, a l l the pulp and paper applicants were anticipating a shortfall i n the amount o f available chips relative to capacity. The ch ip direct ion po l i cy came up again i n the hearings, somewhat surprisingly since it had supposedly been dropped ten years previously . T h e government was pressed on the implicat ions for chip supply problems i f one applicant or another received the fibre, and once again the provinc ia l government decided not to award any o f the pu lpwood wi th in the area. One str iking feature i n reading both pu lpwood hearings is to note how little appears to have changed i n the intervening ten-year period. T h e provinc ia l government subsequently solici ted proposals for addit ional ut i l izat ion o f the forest resource for other areas i n the Interior. T h i s ranged f rom proposals to use aspen i n the northeast corner o f the province to produce pulp and O S B and proposals to use stands o f smal l stagnated pine i n the central Interior. T h e province had many applicants, w i th Lou i s i ana Pac i f ic ( 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 , fo l lowed by an Oriented Strand B o a r d ( O S B ) plant i n D a w s o n Creek (both r e ly ing on aspen). A i n s w o r t h L u m b e r was successful i n rece iv ing the right to construct a fibreboard plant i n the central Interior using the smal l pine found i n the area. T h e government's m a i n contr ibution was through the granting o f cutt ing rights i n the fo rm of new P u l p w o o d Agreements that clearly specified the w o o d to be used for these facil i t ies. In addit ion, F ibreco had previously buil t a chemi-thermomechanical ( C T M P ) pu lpmi l l i n T a y l o r (this p u l p m i l l is now control led by Slocan), and later i t received a P A cover ing aspen i n the surrounding a rea . 5 6 'Chip Shock 67 In 1990 sawmil l s i n the Interior approached then Min i s t e r o f Forests, C laude R i c h m o n d , to again ask for the government to put pressure on the pulp companies to raise their ch ip prices. The minister replied that he w o u l d be unable to help and the N D P w o n the election 5 6 The only additional facil i ty using residual fibre since then has been a M D F plant in Quesnel built by West Fraser in 1997. The plant utilizes softwood chips, but West Fraser did not receive any additional cutting rights. 5 7 The phrase 'chip shock' was first used to describe Weyerhaeuser i n the U S suddenly doubling the price for its exported chips to Japan in 1980 (Marchak, 1995). 47 cal led shortly thereafter (Edgson 1995). L u m b e r prices languished unt i l 1992, when the lumber market started to surge, fo l lowed by the pulp market i n 1994. In February 1994, S locan (the largest independent sawmil ler i n the Interior) announced that it was putting the entire chip supply f rom its Quesnel s awmi l l up for b i d . T h i s had never happened before i n the Interior market . 5 8 Near ly a l l o f the pulp m i l l s i n the region responded, w i th the w i n n i n g bidder, N o r t h w o o d , outb idding C a r i b o o P u l p , w h i c h had traditionally received al l the chips f rom that particular s awmi l l . Th i s activity was watched wi th a great deal o f interest by other sawmil l s throughout the Interior, many o f w h o m prompt ly put their chips up for b i d , and many pu lp m i l l s found themselves s igning contracts at substantially higher prices w i th new suppliers (Edgson 1995)(Bradford 1996) 5 9 . Pr ices o f chips peaked i n 1995 at levels four times greater than they had been on ly 18 months ear l ie r . 6 0 Several pulp and paper m i l l s f i l ed a \"notice o f need\" i n 1994, a p rovis ion under w h i c h they can request the government to halt the export o f chips and have them re-directed to their m i l l . The government response i n 1995 was to not issue any new export permits and not renew to o l d ones as they expired. In addit ion, the provinc ia l government revised stumpage rates i n M a y , 1994, such that at higher prices for lumber the stumpage rate was significantly higher (the new stumpage rates became k n o w n as \"Super Stumpage\"). I was unable to f ind any participant who had any recollection of such an event or any record happening prior to this in the Interior. One participant (from a mid-sized sawmill) recalled that when they had offered some chips previously to a pulp m i l l which hadn't purchased chips from them the pulp m i l l had indicated that they wou ld be interested but first needed to \"check\" wi th the pulp m i l l that was currently purchasing their chips. After checking, the potential purchaser indicated that they were no longer interested. This can be seen in the C h i p Aud i t Task Force report as wel l . Somewhat ironically, several Interior sawmillers suggested in trade discussions with the U S forest industry that part of\" the reason for the success of the Interior forest industry lay in the chip prices they were receiving, due to the competitive nature of the market. The sawmillers suggested that pulp and paper mi l l s i n the U S South had depressed chip prices. 48 T o get more chips, several interior pulp mi l l s also attempted to activate their cutting rights under their o ld P H A s that had been converted into P A s . T h i s has presented a continuing problem for the provincia l government due to the vague definitions o f \"material suitable for pu lp ing\" i n the or iginal agreements. Furthermore, the government found i tself w i t h the problem that some o f this wood was either already commit ted, as part o f long-range harvest projections, or fe l l under more than one license as the or iginal P H A s had been expl ic i t iy overlaid on top o f exist ing forest licenses when they were or ig inal ly established. T h e problem was made more complicated because many sawmil ls had installed whole l o g chippers, g iv ing them the capabil i ty to handle logs too smal l to saw. Three of the or iginal P H A s that have been subsequently renewed i n the past several years have substantially changed terms. 6 1 F o r example, the agreements are no longer renewable and expire at the end o f their terms w h i c h usual ly consist o f 20 years. Furthermore, pu lpwood is now defined as pulp quali ty t imber stands, and is no longer defined as being below sawmi l l ut i l izat ion standards; rather, they m a y fa l l below sawmi l l ut i l izat ion standards f rom t ime to t ime. F i n a l l y , the or iginal agreements stated that t imber w o u l d only be harvested i f the licensee was unable to obtain sufficient fibre be low the cost o f harvesting and processing roundwood itself. T w o of the his tor ical P A s (numbers 3 and 7) no longer require this condi t ion to be met, rather, the company can invoke the P A i f they feel the fibre available on the market is too expensive. T o date, the B C government s t i l l has not indicated how they w o u l d handle a request to use such an agreement. There have also been other noticeable developments. In 1995 Canfor , an integrated company w i t h pulp m i l l operations i n both Pr ince George and on the Coast , attempted a hostile takeover o f S locan . T h e purpose o f the takeover was to secure S locan ' s supply o f 6 1 P A 1, held by Canfor and renewed November 22, 1993; P A 5, held by Cariboo Pulp & Paper and renewed December 16, 1996; and P A 7, held by Canfor and renewed January 24, 1997. 49 w o o d ch ips . In 1996, Orenda Forest Products, w i th cutt ing rights o n the Nor th Coast, announced that an offer had been made to purchase the company subject to i t receiving approval to transfer the t imber cut to Vancouver Island. The pulp m i l l i n Pr ince Rupert that received part o f its pulp fibre requirements f rom Orenda opposed the deal and subsequently acquired Orenda for its cutting rights. Canfor 's attempted takeover o f S locan raised an issue that has been of concern 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 mid-1970s. Press releases by the M i n i s t r y o f Forest at the t ime o f the proposed takeover suggested that Canfor , i f successful, w o u l d control 5 0 % of the loca l w o o d chip market. T h e takeover fai led for at least two reasons: (1) the Min i s t e r stated that he w o u l d v iew the increased concentration wi th concern (and the B C government retains the right to refuse the transfer o f cutting rights); and (2), a share buy-back by S locan . In order to finance the share buy-back, S locan entered into a long-term arrangement w i th Weyerhaeuser for 1 m i l l i o n B D U s over the next ten years; on an annual basis, this is about 16% o f their 1993 p roduc t ion . 6 2 A s part o f the buyback, however , S locan agreed to Weyerhaeuser taking a 2 0 % interest i n S locan i n the event o f a default. T h i s has raised concerns among other independent s awmi l l i ng companies, since S locan is the largest seller o f w o o d chips i n the Interior. Canfor has subsequently purchased a minor i ty interest i n three o f the largest remaining independent sawmil ls i n the Pr ince George area. Poor pulp markets, coup led w i t h h igh fibre inventories, f o l l o w i n g the spike i n prices i n 1995 l e d to ch ip prices tumbl ing back to the levels o f the early 1990's . Subsequently, however, ch ip price levels have remained sl ightly above those i n the past, whi le prices are more wide ly dispersed than i n the past. Once again, the possibi l i ty o f sawmi l l s shutting d o w n due to the state o f pulp markets was being d i scussed . 6 3 Slocan Annua l Report 1996. See, for example, the various articles that have appeared in the Vancouver Sun: B C Forestry in perilous position, November 29, 1996; Stumpage Fees going up, industry warned, November 29, 50 One o f the major news stories over the past year i n the forest industry has been the economic woes of the pulp m i l l i n Pr ince Rupert owned by Skeena Ce l lu lose . Af te r miss ing much o f the h igh pu lp prices i n 1995 due to a strike, the pulp m i l l came back on l ine just as pulp prices started to tumble. Short ly thereafter A v e n o r undertook discussions w i t h the parent company, Repap , over purchasing Repap ' s assets. D u e to Repap ' s h igh debt load, and the unattractive economics o f Repap ' s B C pulp m i l l , w h i c h relies on pulp logs as w e l l as w o o d chips f rom the Interior, Repap divested itself o f its who l ly -owned B C subsidiary (wh ich also inc luded several sawmi l l s i n the northwestern part o f the province) . T h i s threw the B C subsidiary into bankruptcy and into the arms o f the two banks, Toronto D o m i n i o n and R o y a l Bank , that he ld the major por t ion o f the debt. T h e provincia l government made the pol icy decision that i t could not let the pulp m i l l close due to the negative economic impact it w o u l d have on the surrounding r eg ion . 6 4 Ini t ia l discussions l ed to the province advancing the company funds and then purchasing R o y a l B a n k ' s interest, assuming a majority equity share i n the company. T h e government has also provided f inancing assistance to defray logging and forest management expenses, as w e l l as deferring stumpage payments and relaxing ut i l izat ion standards. The total cost to taxpayers is estimated to be over $300 m i l l i o n , mak ing it the most expensive a id package i n the history o f the province. However , 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 productivi ty, and its prospects are somewhat uncertain i n the face o f current l ow pulp prices. One pulp l ine continues to remain id led as o f early 1999 as pulp prices have fai led to reach sufficient levels to warrant restarting the product ion l ine . In summary, the development of the pulp and paper industry i n the Interior has been intertwined w i t h that of the s a w m i l l industry and government po l i cy . T h e creation o f a market for wood , 1996; Terrace sawmil l to shut down, logging costs cited, November 28, 1996; Problems just tip of the iceberg in B C , November 2, 1996. 6 4 Th is also happened after the government had introduced the much-touted Jobs and Timber Accord , which promised to provide substantial new numbers o f jobs in the forest industry. M a n y observers felt that the government simply could not let such a visible portion of the forest industry close given the polit ical rhetoric surrounding the Acco rd . 51 previously wasted, simultaneously provided the basis for the pu lp industry i n the Interior i n the f o r m o f an abundant and low-cost source o f fibre whi le br inging stands that were previously considered unmerchantable wi th in the economic margin o f the Interior s a w m i l l i n g industry. B o t h sectors grew rapidly as harvest levels , lumber product ion, and residual ch ip product ion increased, complement ing 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. Changes dur ing that per iod i n both the allocation o f t imber rights and charges for t imber have reflected that interdependence: higher stumpage charges have led to increases i n ch ip prices, whi le issues o f chip and pu lp fibre supply has been behind m u c h o f the recent restructuring i n the B C forest indus t ry . 6 5 In 1999, however , many o f the issues fac ing the industry i n the Interior arise f rom the impl ica t ions o f decreasing fibre avai labi l i ty due to the reduction i n A A C . T h e development o f engineered w o o d products has increased the demand for residual w o o d chips, wh i l e techniques such as finger-jo in t ing w h i c h ut i l ize w o o d residue that was formerly chipped, have decreased the supply. Overshadowing those trends have been reductions i n harvest levels and greater reliance on poorer quality t imber that are also changing the structure o f the Interior market w i th implicat ions for the cost o f pulp fibre and the al locat ion o f f ibre . T h e provinc ia l government finds i tself facing increasingly diff icult po l i cy choices. In the past, the traditional approach to economic development i n the forest industry has been to grant access or tenure rights to process the fibre by industr ial users. N o w , however , i t is diff icul t for the government to f ind any uncommitted fibre. Furthermore, the price cycles are shorter and o f greater amplitude, and changing technology make i t diff icult to establish what uses w i l l provide the highest economic value i n the future. Ex i s t i ng operators argue that any available fibre should be used to sustain their operations and to maintain current employment. O n the B C Coast, M a c M i l l a n Bloedel spun off its pulp and paper divis ion in two steps, forming two new companies, Harmac Pacific in 1994 (subsequently acquired by Pope & Talbot) and Pacif ica in 1998. Timberwest divested itself of its public cutting rights which were sold to Doman, which has two pulp mills on the B C Coast. 5 2 F i n a l l y , increased stumpage charges over the past several years have led to much lower economic margins for the forest industry and losses for some, and the government n o w faces the additional issue o f ensuring that stumpage prices are appropriately set and accurately measure t imber values. T h i s task also becomes more diff icult i n the face o f rapidly changing product prices. A t this point, then, i t is instructive to examine the economic forces that determine prices for pulp fibre and what impacts these changes have on pulp 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.\" , Guthr ie 1950 Market Power and Price Discrimination Forestry economics has long recognized the potential for imperfect markets i n forest inputs. T h e economics o f processing raw material usually makes it is less costly to process i t as close to the harvesting site as possible, g iven the h igh transportation costs per unit o f raw material . S ince forests tend to be quite w ide ly dispersed and distant f rom end markets, i t is quite c o m m o n then for there to be l imi ted numbers o f potential buyers i n standing t imber markets (Gregory 1987). M e a d (1967) investigated the issue o f competi t ion i n his classic work on federal t imber markets i n the U S Pac i f ic Northwest and showed that as the number o f buyers increased the w i n n i n g bids for publ ic t imber were higher. M e a d also showed that larger f i rms were able to successfully acquire federal t imber at lower cost than their smaller competitors. The problem o f market power becomes even more acute i n the pulp and paper industry, as the large economies of scale prevalent i n the pulp and paper industry increase the size o f harvesting areas, further reducing the l ike l ihood o f alternative buyers. T h e pr ic ing o f p u l p w o o d and w o o d chips has not only been a concern i n B C (Nelson et a l . 1994, Gas ton et a l . 1995), but also i n t imber markets i n Canada and the rest o f the wor ld : Quebec (Olson 1989); Ontario (Nautiyal 1995); N e w 54 B r u n s w i c k ( R u n y o n 1983); A lbe r t a (Geldhart and C a r r o l l 1980); Aus t ra l i a (Parker 1988); Sweden (Johansson and Lofgren 1983); and the U n i t e d States (Mur ray 1992). Marke t power can be defined as the abi l i ty o f one or more o f the participants i n a market to influence the price l eve l on a sustained basis through their actions. T h i s stands i n sharp contrast to perfectly competi t ive markets, where there are so many buyers and sellers that no indiv idual party has the abi l i ty to affect the market price level through their actions. In essence, there is no market power; a l l sellers are \"pr ice takers\"; and f i rms as buyers are price takers as w e l l . 6 6 T h e goal o f f i rms wi th market power is to increase their profits, and the most c o m m o n firms use to pursue that goal is through using their abi l i ty to affect price levels (P indyck and Rubinfe ld 1989). T h e standard mode l used to examine market power on the purchasing side is that o f a monopsony, where a single f i r m is the on ly purchaser o f a good or service. Because the monopsonist recognizes that as i t increases its purchases that i t raises the price i n the market, i t w i l l choose the price and quantity combinat ion that m a x i m i z e its profits. Under such circumstances the monopsonist uses its market power to pay a price lower than w o u l d prevail i n more competi t ive markets. F i g u r e 4 shows that i n a competit ive market, the quantity O E w o u l d be purchased at a price of O B where supply (S ' ) is equal to demand (D) . A pulp m i l l w i th market power w o u l d choose to purchase the quantity O C and pay O M , where the marginal expenditure ( M E ) equals the marginal revenue (D) . B y paying a lower price, the pulp m i l l is able to extract producer surplus f rom the suppliers equivalent to the rectangle B M G H , wh i l e society faces a deadweight loss equivalent to the triangle F H J . The concept of a f i rm's abili ty as a determinant of market power lies behind the idea of contestability used in the analysis o f monopolies. Even though a monopoly may possess the power to change prices in its market, it may be unable to raise prices above its costs due to the possibility of entry by other firms. Al though the f i rm can meet the demand i n the market, i f it attempts to raise prices another f i rm can enter the market at an infinitesimally lower price and supply the entire market. A i r l i n e routes are the typical examples of contestable markets. Figure 4. Pricing Under Competitive Conditions and Under a Monopsony , A firm wi th market power w i l l find that it may be able to increase its profits i f it can pay different prices to different sellers o f an input. In F i g u r e 4, the pulp m i l l cou ld increase its profits by the triangles A M H and G H I i f it cou ld pay just enough to each supplier to cover the costs o f product ion ( in this case, the l ine A I ) . In this case, the pulp m i l l is practicing price discrimination. Pr ice discr iminat ion occurs whenever a firm charges (or pays) different prices for the same good (where a l l differences i n the product due to quali ty, date o f del ivery, quantity, or transportation costs have been accounted for) to different buyers (sellers). A s a general rule, profits increase under price discr iminat ion. In the example above, the firm was practicing perfect or first-degree price discrimination: each supplier received just enough to induce them to offer their supply and the purchaser is able to completely capture a l l the producer surplus i n the case o f a seller pract icing perfect price discr iminat ion, it captures a l l of the consumer surplus). A more c o m m o n practice is third-degree price discrimination where customers (suppliers) can be separated into different groups that have different demand (supply) curves. T h e firm can then establish different prices for each group based on some characteristic that i t can use to dist inguish between the different groups (and must be able to prevent arbitrage). In order for this strategy to be successful, the purchaser has to be able to identify the source for a particular supply, as different prices may make i t profitable for a group that receives a lower price to try and market its supply as c o m i n g f rom the higher pr iced group . 6 7 Note that even i f suppliers i n different locations receive the same net price, the purchaser i s paying different prices as the cost o f the good includes transportation costs. A n y comparison of the prices pa id for goods has to include a l l costs o f getting the good to the m i l l , inc lud ing any quali ty or transportation differences as w e l l as transaction costs. 6 7 One common example o f such arrangements for firms selling goods are special prices for students and seniors. In terms of such arrangements on the purchasing side, B ink l ey (1991)observes that pulpwood buyers in the Amer ican Southeast may set up area or zone-specific prices. 57 W h e n there are few f i rms purchasing a good the market structure is described as an oligopsony. Firs t or third-degree price discr iminat ion may be present under an oligopsonistic market structure; however, the nature o f the market may be such that the purchasers are unable to exercise any market power whatsoever. Oligopsonists face the problem that to the extent f i rms are successful i n earning true or economic profits, an incentive is created for f irms to try to \"cheat\" (paying sl ightly more to receive more o f the good). I f a l l f i rms engage i n such behavior, the prices w i l l revert to more competit ive price levels (one example o f this for an o l igopoly has been the inabi l i ty of the O P E C cartel to sustain the high o i l prices they agree to i n their annual meetings). T h e inabi l i ty o f firms to ful ly coordinate their behaviour i n an o l igopoly or ol igopsony adds an addit ional layer o f complexi ty i n t rying to understand the exercise o f market power. Models of Pulpwood Markets Because pu lpwood markets c o m m o n l y exhibi t the characteristics that are assumed to be associated wi th market power, such as l imi ted numbers o f purchasers relative to suppliers, several models have been developed to examine imperfect competi t ion i n pu lpwood markets. L o w r y and Winf rey (1974) pointed out that i n the U S Southeast that pulp and paper companies w i l l source more expensive pu lpwood f rom their o w n forestland at a cost that is higher than purchased pu lpwood . T h e y argue that the purchaser believes that the pu lpwood supply curve is very inelastic; any increase i n demand is l i k e l y to br ing about rapid increases i n price without increasing supply substantially. L o w r y and Winf rey 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 acquisi t ion o f additional t imberland. B juggren (1992) uses the same argument to expla in why Swedish pulp m i l l s w i l l import far more expensive roundwood , rather than attempting to purchase more domestic roundwood when they require addit ional f ibre, an argument also used by Johansson and Lofgren (19S3) to explain apparent excess demand i n the S w e d i s h roundwood market. In these cases, f i rms exploi t pre-existing market segments to take advantage o f differing supply elasticities. 6 8 They also argue that the price is sticky; once the price has increased, it is unl ikely to fall as 58 Gas ton , N e l s o n , and Stanbury (1995) use such a mode l to expla in price discr iminat ion i n the B C Coastal pulp fibre market, where the relatively inelastic production o f wood chips, compared to the more elastic supply o f pulplogs, permits purchasers to pay markedly less for residual chips than for roundwood chips . 6 9 7 0 Another approach has been to incorporate the interaction between market power and locat ion where f irms act as spatial monopsonists and practice price discr iminat ion. B i n k l e y (1991) examined pr ic ing systems for pu lpwood i n the U S South and showed the advantages o f zone p r i c ing , where purchasers establish prices for a particular supply area to take advantage o f differing supply elasticit ies. 7 1 Lo fg ren (1985), using a spatial monopsony mode l , shows that the opt imal p r ic ing system depends on the elasticity o f the supply curve, and argues that the resulting price system i n Scandinavia therefore reflects a concave supply curve. Geldhart and C a r r o l l (1980) propose a model of first-degree price discr iminat ion where the delivered cost to the pulp m i l l varies directly w i t h the transportation cost t and the suppliers, or sawmi l l s , are ordered by distance. In the mode l , a l l sawmil ls have the same cost o f ch ipping and can produce equal amounts o f chips i f their supply price is met (the supply is f ixed for each ind iv idua l s awmi l l and overal l supply is increased by purchasing f rom additional sawmil ls ) . I f the pulp m i l l can pay supplier-specific prices, it w i l l then purchase out to the point where marginal revenue equals the marginal cost, just cover ing the cost o f suppliers become accustomed to the higher price. Comparison o f roundwood and residual chip prices requires taking into account differences in quality that may arise between the two different types of chips. These differences stem from such factors such as species, chip geometry, and the relative proportion o f contaminants (bark, knots, etc.) which ultimately determine the quality. Variat ion between the two appears to be greater depending upon the specific producer rather than the specific process! In this case, roundwood chips were selling at 50% or greater premiums, wel l outside the normal variation associated with quality differentials. In U S markets, the two types of chips are usually equivalent in price. This suggests that the use of two-tier pricing in the early 1970's in the Interior, which paid a higher price for \"incremental\" volumes of chips, differentiated between the relatively inelastic supply o f residual chips under \"normal\" conditions ion of chips, and the more elastic supply of wood that could be obtained by ut i l iz ing wood that was then currently being burned or put into landfills. However, the subsequent use of incremental prices in later years was more l ike ly to increase the production of chips by chipping low-grade lumber, as by this time the amount of additional fibre that could be recovered at the mi l l was negligible. B ink l ey notes the use of special non-cash tickets used in part to pay suppliers as a means of preventing arbitrage. 59 chipping and the transportation cost to that particular s awmi l l . T h e mode l then yields a uniform sawmi l l price w h i c h just covers the cost o f ch ipping , and where increases i n demand lead to the ut i l izat ion o f more and more distant producers f rom sawmi l l A to sawmi l l E (as seen i n F i g u r e 5). T h i s mode l is discussed further i n Chapter 3 . These models o f pu lpwood procurement assume f i rms act as monopsonists and do not incorporate interaction between firms. B y turning to the broader literature i n v o l v i n g game theory and industrial organization i t is possible to f ind a r ich set o f models , w h i c h incorporate market structure, f i r m interaction, and price discr iminat ion. Models of Spatial Pricing and Market Power W h a t happens when market power is translated into geographic space? T h e starting point for most models is that o f a spatial monopolist . A single f i r m faces customers w i th identical demands who are spatially dispersed (usually uniformly along a l ine segment for ease o f exposition) and there are posit ive transportation costs, so their net demands as seen by the f i r m vary. T h e monopol is t may choose to s imply set their price at the factory gate and let customers arrange for transportation. If, however, the f i rm takes care o f del ivery and does not a l low the buyer to p i ck up the good at the plant, then, the f i rm can practice a particular type o f third-degree price discr iminat ion cal led spatial price discrimination by charging customers prices specific to their locat ion (net o f transportation costs). These prices w i l l be both a function o f the distance between the customer and f i r m and the buyer 's demand elasticity (this price inclus ive o f a l l costs is commonly ca l led the delivered price). The price level or mill price (that is , the price at the f i rm ' s location) and the slope o f the del ivered price schedule vary wi th these parameters. A s demand becomes more inelastic, the price leve l w i l l rise and the delivered price schedule w i l l flatten (these and the f o l l o w i n g results also ho ld true 72 when market power is on the purchasing side). 7 2 Var i an (1989) shows that the delivered price depends on both the first and second derivatives o f the demand function. When the demand function is linear, the price increases by one-half o f the transportation cost, while 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 delivered price schedule when a f i r m is setting prices for customers that are uniformly distributed along a l ine segment and have identical demand curves. A s the f i r m takes care o f del ivery, the price the customer faces includes both the cost o f the good, C , and the transportation cost, t, to the customer's locat ion. Since demand effectively falls wi th distance (since more distant customers are facing higher prices due to higher transportation costs), the f i r m takes this effect into account when determining the delivered price. A s demand becomes less price elastic (decreases f rom e l to e2), the f i r m w i l l raise the price leve l or m i l l pr ice f rom P l to P 2 , but decrease the slope o f the del ivered price schedule. Pr ice discr iminat ion increases, as measured by the difference i n net realizations to the f i rm . In these models different spatial pr ic ing systems 73 s imply reflect different underlying elasticities o f demand or supply. A we l l -known result i n welfare economics i s that where a l l markets are perfectly competi t ive (and so price equals marginal cost) the result is a Pareto O p t i m u m . T h i s result can be extended into space, where prices equal the marginal cost o f production plus transportation costs to a customer 's locat ion. T h i s type o f p r i c ing , also k n o w n as FOB pricing, is often used as a benchmark for competi t ive prices (see, for example, models by Mougeo t 1975, Thisse 1975, and Greenhut et a l . 1987). However , there are no such clear-cut results for imperfect markets when space becomes a factor. F O B pr ic ing may or may not arise under competi t ive behavior, and cannot be used as the sole criterion to establish whether a market is competi t ive or not (Phl ips 1983). Instead, competitiveness becomes a model-specific defini t ion, dependent upon the assumptions o f the m o d e l . One o f the ways the intensity o f competi t ion can be incorporated i n the analysis is through different assumptions about the structure o f the market. T h e classic mode 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 ie ld delivered price schedules that vary by more than the transportation cost to that location (this is called phantom freight). Such results are usually ruled out arbitrarily by the invocation of arbitrage so that prices w i l l then fol low an F O B system. 6 1 Figure 5. Price Discrimination in a Wood Chip Market and locational differences is the spatial duopoly mode l used by H o t e l l i n g (1929) to study horizontal differentiation. In the basic mode l , two f irms wi th constant marginal costs are located at opposite ends of a l ine segment. The f irms face customers uniformly distributed along the l ine segment between the two, where the customers have identical unit demands and incur posit ive transportation costs i n traveling to either f i rm . The N a s h equi l ib r ium yields prices based on the f i rms ' marginal cost and transportation cost w i th posit ive profits; however, i f transportation costs are zero the result is a Bertrand equi l ib r ium wi th marginal cost p r i c i n g . 7 4 W h e n both f i rms are located at the same point, the equ i l ib r ium is again Bertrand wi th zero profits and marginal cost p r i c ing regardless o f transportation costs. T h e mode l suggests that the competitiveness o f a market is determined by the locat ion o f f irms, and that f i rms may be able to enjoy profits even i n competi t ive markets. In the case o f an ol igopsony, this suggests that competi t ion w i l l lead to higher prices when firms are located coincidental ly than when they enjoy loca l monopsonies . T h e mode l does not specif ical ly address the issue o f different p r ic ing systems. Greenhut and Greenhut (1975) address the issue o f del ivered p r ic ing systems i n their mode l . F i rms have constant marginal costs and are located at the same endpoint o f a l ine segment, w i th customers w h o have ident ical demands and who are uniformly distributed along the l ine segment. T h e f i rms ' p roblem is to then max imize profits by deciding what del ivered prices to set, when f i rms engage i n Cournot conjectures about how the other firms w i l l react. T h e f irms take care o f a l l transportation and the delivered price includes a l l costs to the customer's locat ion. T h e slope o f the delivered price schedule can 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 locat ion, pay the same delivered price. Where the price varies by the actual transportation cost, this is considered FOB pricing, and when the del ivered pr ice is the same, this i s ca l led uniform delivered pricing (UDP). I f the delivered price is somewhat intermediate then freight absorption is taking place, i n 7 4 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 iven a c o m m o n m i l l price, the delivered price is less than the fu l l 75 transportation cost to any customer. T h e authors then show that as more f i rms enter the same location, the m i l l price falls and the slope o f the delivered pr ic ing schedule increases. A s the number o f f irms approaches infini ty, the m i l l net price falls to marginal cost and the slope o f the del ivered price approaches the transportation cost. F i g u r e 7 illustrates how the m i l l price falls f r o m P l to P2 and the slope o f the delivered price schedule approaches actual transportation costs as the number o f f i rms increases (from N l to N2). In this mode l , increasing competi t ion (as defined by the entry o f new f i rms at the same location) leads to F O B pr ic ing at marginal cost, or non-discriminatory pr ic ing . F o r an ol igopsony, F O B pr ic ing is the equivalent o f a uni form price at the purchaser 's gate, w i th each supplier 's net price differing by the transportation costs between their locat ion and the purchaser. T h e equivalence i n the case wi th F O B pr ic ing arises f rom the fact that the f i rm perceives no difference i n any supplier 's costs, regardless o f the locat ion o f the supplier, wh i l e under F O B pr ic ing the f i r m w o u l d see no difference i n the net revenue f rom any customer, regardless o f the customer 's locat ion. In the mode l above, then, suppliers w o u l d receive rents as prices increase and locational rents as the market becomes more competit ive and prices move towards a uni form price at the purchaser 's gate when firms are i n the same locat ion. Furthermore, price discr iminat ion w i l l decrease as competi t ion increases. Greenhut and Greenhut (1975) then look at the entry o f firms at the other endpoint o f the l ine segment and assume that there is complete market overlap. In this case, the endpoint w i t h the greater number o f firms determines the m i l l pr ice and delivered price schedule. However , i f the number o f firms at each locat ion is equal, then the delivered price schedule is perfectly horizontal (the same to any customer, regardless o f locat ion) , and U D P prevails . A s the number o f firms 7 5 This term is somewhat misleading since the delivered price can be well in excess of the actual production and transportation cost, while the term is commonly used to suggest that somehow costs are being absorbed by the firm or by one set of customers at the expense of another set. So long as the delivered price exceeds al l costs to any customer, the presence o f freight absorption simply reflects the ability of 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 From Greenhut and Greenhut (1975) 65 increase, regardless o f their locat ion, prices m o v e towards a U D P system, so price discr iminat ion is increasing. F ina l ly , the authors look at market areas that are only part ial ly overlapped. In this case, the delivered p r ic ing schedule w i l l tend to be flatter i n the overlapped area where there are more firms competing (that is , tending towards U D P ) . F i g u r e 8 shows a k i n k i n the delivered price schedule where there is market overlap between the N l f i rms at one end o f the l ine segment and the N2 firms at the other end (effectively, the number o f firms serving this segment of the market is N l + N2). Under this mode l , increased compet i t ion due to the presence of more firms wi th in that market area leads to a flatter price schedule and increased price discr iminat ion. In the case o f an ol igopsony, then, movement towards a U D P pr ic ing system (where the net realization decreases by the actual transportation costs) is the equivalent o f purchasers m o v i n g towards pay ing a un i form price to the suppliers ( U S P ) (where the total costs increase by transportation costs). G i v e n a c o m m o n price across suppliers, then, the avai lable rents depend on ly on the price level and not on locat ion. T h i s mode l suggests that when firms are spatially separated increasing competi t ion w i l l lead to increasing price discriminat ion. N o r m a n (1981) has also offered several models i n w h i c h the degree o f spatial price discr iminat ion relies o n the amount o f competi t ion. In one model , spatial price discr iminat ion i s greater when two coincidentally-located oligopolists col lude, whi le co l lus ion between non-coincidental ly located ol igopolis ts leads to more ambiguous results. In another mode l , the firm chooses a l inear p r i c ing pattern, subject to the constraint o f a ce i l ing or spatial l i m i t price, where this l imi t price reflects competi t ive conditions and the potential entry o f new firms, and where customers have identical demands. If the spatial l i m i t price is not b ind ing , the firm acts as a spatial monopolis t , choosing the price at each locat ion that equates marginal revenue and marginal cost (wh ich is inclusive o f the transportation cost). T h e slope o f the delivered p r ic ing schedule w i l l then vary, depending o n the elasticity o f the ind iv idua l demands, as i n Greenhut and Greenhut (1975). Howeve r , as the spatial l i m i t price becomes b inding , the firm moves towards greater price discr iminat ion, 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 uniform delivered pr ic ing po l i cy when the l i m i t price binds over the entire market area. These models show that the relationship the opt imal p r ic ing system may depend o n a variety o f factors: the degree o f concentration (as expressed i n the number o f f i rms); demand or supply elasticities; and the locat ion o f firms. Furthermore, the presence or absence o f discriminatory pr ic ing arrangements cannot be used to establish the competitiveness o f a market. Profit-m a x i m i z i n g firms can move towards either F O B pr ic ing or U D P as competi t ive pressures become stronger, depending on the structure o f the market and other assumptions. T h e same result carries over into an ol igopsony setting; depending o n the market structure (e.g. the number o f firms and/or their location), increasing competi t ion can lead to either uni form prices at the purchaser's locat ion or the supplier 's . W e are then left w i t h the rather inconclus ive result N o r m a n (1981) notes: \"The existence o f spatial price discr iminat ion i n particular markets is not a priori evidence of l ack o f competi t ive pressures. B u t neither can a s imple connect ion be drawn between the degree o f competi t ion and the degree o f spatial price discr iminat ion. Disc r imina t ion between spatially separated consumers.. .may indeed reflect and be the result o f intense competi t ive pressures i n particular markets, but this is more l i k e l y i f the competitors i n such markets are not themselves spatially concentrated. O n the other hand, discr iminat ion m a y be the consequences o f co l lus ive agreements between coincidental ly located producers, or o f attempts by such producers to anticipate the actions o f their competitors.\" Delivered Pricing Systems One reason the issue o f spatial price discr iminat ion has received so m u c h attention is that spatial variations i n p r ic ing are observed i n a variety o f markets. A c o m m o n practice for many industries where transportation costs can be significant has been the use of delivered pricing systems. These systems calculate expl ic i t spatial prices according to some specific formula employed by sellers i n the industry. These type o f systems have received considerable economic attention over the years. Some authors have noted that del ivered pr ic ing systems, by a l l o w i n g the possibi l i ty o f setting customer or supplier-specific prices, can lead to higher profits. T h i s possibi l i ty may support more col lus ive behavior as firms perceive the benefit f rom coordinating prices. Other authors have countered that such systems instead reflect competi t ive forces and s imply show how firms meet 68 competi t ion on a spatial basis. These systems m a y or not m a y display spatial price discr iminat ion, depending upon the formulas invo lved . One example o f a delivered pr ic ing system is a basing point system ( B P ) . In a basing point system, the price delivered to the customer's door is calculated as a c o m m o n price at some particular f ixed point (the base price), plus the notional transportation costs f rom that point to the customer's l o c a t i o n . 7 6 Consequently, a l l f i rms charge the same identical delivered price to a particular customer's locat ion, regardless o f any one seller 's locat ion. In one variat ion, there may be mult iple basing points, and firms may 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 . 7 7 Understanding the economic reasons for these types o f systems has been the just i f icat ion for m u c h of the work done on del ivered pr ic ing schemes and especial ly basing point systems (see Fetter 1937, M a c h l u p 1949, Loescher 1959, Scherer 1980, and G i l l i g a n 1992 for various studies). Bas ing point systems were c o m m o n i n the Uni t ed States i n the early part o f the century, unti l the Federal Trade C o m m i s s i o n found such schemes lessened compet i t ion (Espinosa 1992). E m p i r i c a l w o r k by Greenhut , Greenhut, and L i (1980) has suggested that many h ighly concentrated industries w i th a h igh degree o f spatial differentiation such as cement, steel, and corn, d i d use del ivered pr ic ing schemes i n the U S . St igler (1949) offers instances where cartelization coincided 78 wi th the dropping o f an F O B pr ic ing system and the introduction o f a del ivered pr ic ing system. Stigler (1964) examined basing point systems and suggested they m a y be more l i ke ly to arise i n industries where demand was geographically unstable (for example steel and cement). In his v i ew, basing point systems offered an orderly way for f i rms to extend their sales area when they found demand was l o w wi th in their area without the r isk o f precipitating price cuts. H e noted that the system, wh i l e p rov id ing an outlet for some firms, tended to reduce the attractiveness o f more 7 6 The classic basing point system examined in the economic literature was the \"Pittsburgh plus\" system that expressed steel prices as the price of steel i n Pittsburgh delivered to a particular location, even i f the steel was supplied by a m i l l somewhere other than in Pittsburgh. 7 7 One common rule is that the lowest delivered price should apply. 7 8 This happened i n both the German cement industry and the Br i t i sh bituminous coal industry. 69 distant markets. Leuschner (1952) also showed how a basing point system through the use o f punit ive bases cou ld be used to punish a firm that deviated f rom the system. D u e to differences i n antitrust l aw , delivered pr ic ing systems are more c o m m o n i n Europe. Ph l ips (1981) discusses the use o f uni form del ivered prices i n two markets where firms ho ld market power. T h e first case is that o f B r i t i s h Plasterboard, w h i c h has a monopo ly i n the Un i t ed K i n g d o m , and sells plasterboard at a un i form del ivered price throughout the country. T h e second example is that of 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 locat ion o f the buyer relative to the closest plant. Haddock (1982) offered an alternative v i ew o f del ivered pr ic ing systems, arguing that basing point schemes can emerge i n competi t ive 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 basing point systems reflected competi t ion among firms located at the basing point, wh i l e firms elsewhere used the basing point system to a l ign their prices w i t h their rivals. Thisse and V i v e s (1988), however , showed that basing point p r i c ing on ly emerges as the outcome o f a non-cooperative game when one firm chooses a sub-optimal strategy (this mode l is discussed more fu l ly i n Chapter 3). Espinosa (1992) argues that identical uni form delivered pr ic ing systems can be very competi t ive. W h e n a l l firms are charging the same price, any change i n one firm's price can cause a dramatic change i n its market area and hence the other firms' market area. Compared to a F O B pr ic ing system, where the effect o f a change is l i ke ly to be more local ized , this greater degree o f interpenetration means that such a system can lead to far more competi t ive behavior. Esp inosa (1992) bui l t such a mode l to examine the relationship between market structure, p r i c ing systems, and changes i n competi t ive behavior, and showed that competit ive markets can have either un i form del ivered prices or F O B prices depending o n the loca t ion o f firms. Furthermore, the degree o f compet i t ion, and the type o f system, depend o n exogenous variables such as firm's discount rates, transportation costs, and customers ' reservation values, and firms w i l l swi tch between the two different p r ic ing systems as these variables change (this mode l is also discussed more fu l ly i n 70 Chapter 3) . Esp inosa (1992) offered the observation that after the U . S . Supreme Cour t outlawed basing-point p r i c ing systems i n 1948, both the cement and steel industries moved to an F O B pr ic ing system and both prices and revenues increased i n each industry. She suggests that i n this case the delivered pr ic ing system facilitated competi t ion, and that by dropping i t such competi t ive pressures were eased, although she does not provide any detailed empir ica l data to support such a conc lus ion . Duerr (1994) notes that i n the U S South, after W W I I , pulp and paper m i l l s m o v e d f rom a uni form del ivered pr ic ing system for purchasing pu lpwood to a system where m i l l s set prices so that they were uni form across a l l suppliers (which he cal ls local pricing). Duerr attributes the change to increased competi t ion, as the number o f pulp m i l l s i n the area increased, although he does not provide any theoretical justif ication. Espinosa 's (1992) mode l incorporates the issue o f f i r m interaction i n a spatial context that is mis s ing f rom the previous static models introduced. In do ing so, she shows that f i rms , through recogniz ing their interdependence, may be able to sustain payoffs different than those under competi t ive assumptions through changing their responses to ( one another's actions. H o w these f irms alter their responses, then, raises the issue o f what factors m a y influence f i r m behaviour, as w e l l as the idea that observed pr ic ing systems may reflect something more than the under lying market structure. Firm Behaviour and the Effect on Market Outcomes Economis ts ' ma in concern over ol igopolies stemmed in i t ia l ly f rom firms acting i n a coordinated fashion to sustain monopo ly prices through cartels or other pr ice-f ix ing agreements. Such overt co l lus ion was c o m m o n i n Nor th A m e r i c a i n the early part o f the century, but due to their and-79 competit ive nature many o f the practices f irms employed were eventually outlawed. Chamber i in 7 9 There are a variety of cases. One of particular interest was the investigation in 1956 of pulpwood procurement in Eastern Canada. A Roya l Commiss ion found that pulpwood buyers (mainly domestic pulp mills) had agreed on both prices and pricing practices. A convict ion was obtained 71 (1929) was the first to suggest that f i rms, through their recognit ion o f their mutual interdependence, might s t i l l act i n such a way as to sustain the monopoly price without necessarily cooperating overtly. A l t h o u g h firms w o u l d st i l l engage i n non-cooperative behavior, their recognition o f the nature o f the market might be sufficient to deter them f rom competit ive behavior. F o r example, a f i rm w o u l d realize lower prices might in i t ia l ly lead to greater market share for one f i r m , temporari ly raising profits, but ul t imately w o u l d y i e ld a price war that w o u l d depress a l l f i rms ' profits, i nc lud ing its own . Therefore, a l l the f i rms i n the industry w o u l d mutua l ly refrain f rom lower ing the price, and i n doing so raise their long-run payoffs above the m i n i m u m leve l . Such outcomes are said to be tacitly collusive. A s Ph l ips (1981) states, \" . . i n a legal environment where expl ic i t pr ice agreements are not enforceable, so that jo in t profit max imiza t ion is not a possibi l i ty, ol igopolists are supposed to replace expl ic i t agreements by \"tacit co l lus ion\" i n the standard antitrust literature. These tacit agreements are supposedly reached through an exchange o f information on prices, sales condit ions, and possibly other relevant data such as product ion data and investment projects.\" Phl ips (1981) then points out that delivered pr ic ing systems can also facilitate col lus ive Of) outcomes. Factors that Influence Firm Behaviour Scherer (1980) outlines a number of factors that can a id or hinder co l lus ion . These include: the number and size distribution o f sellers; product heterogeneity; cost structures; lumpiness and infrequency o f orders; secrecy and retaliation lags; and industry social structure. A l l o f these point to the two central issues. H o w easily can f i rms coordinate their actions to raise payoffs, and i f f i rms are successful i n ra is ing payoffs, how can defection (or cheating) be discouraged? under the Combines Investigation A c t in 1960 (see Regina v. Ab i t i b i Power & Paper C o . L t d . 1960). ' T h e adoption o f a particular pricing technique may, in a spatial framework, have direct implications for the probability of detecting deviating behaviour and thus for the ease wi th which equi l ibr ia are found and maintained.\" (Phlips 1981:46) 7 2 Scherer (1980) noted that few sellers (or buyers) eases co l lus ion by reducing the number o f potential players to coordinate and monitor, and also makes the effect o f their o w n actions more ' o b v i o u s . 8 1 In addition, product homogeneity means that a l l f i rms ' goods are s imi lar , and by str ipping away other attributes, it leaves pr ic ing as the on ly issue to be resolved. B y focusing oh on ly one aspect, it reduces the coordination problem by both reducing the complexi ty o f the problem as w e l l as mak ing it easier it is to identify when price concessions are given. Scherer (1980) identifies four classes o f heterogeneity, one applicable i n a spatial context. That is when products are differentiated by transportation costs, and Scherer (1980) refers to the literature on basing point systems as a means of addressing that heterogeneity. T h e third factor is cost structure. Scherer (1980) argues that firms w i t h h igh fixed costs w i l l be more l i k e l y to deviate because i n periods of h igh demand, fa l l ing average costs are an added benefit to increased production. T h e frequency o f orders is l i ke ly to determine how often firms interact. If, for example, there are large infrequent orders, firms may be more inc l ined to compete for them than i f there was a more even f low o f orders. Secrecy is the cri t ical factor i n determining whether or not a col lus ive arrangement is sustainable. If firms are unable to monitor or determine when a participant is deviat ing f rom the system, the l i ke l ihood o f such a deviat ion is increased. Furthermore, firms may have diff iculty dist inguishing between natural uncertainty and uncertainty about firm behavior. F o r example, does unexpectedly l o w demand for one firm signal that another is undercutting i t or that demand has temporarily dropped? 8 1 ' T h e number o f two-way communication f lows required is given by the combinatorial expression N ( N - l ) / 2 ; that is, for two sellers, the number of channels is one; wi th six, it rises to 15, and so on . \" (Scherer 1980: 200) 73 A l o n g wi th secrecy, retaliation lags are also a factor. M u c h l ike infrequent orders, i f a f i r m feels that any punishment for deviat ing is \"far enough\" away, it may not f ind the proposed punishment sufficient to deter i t f rom cheating. F i n a l l y , Scherer (1980) suggests that industry social structure may be important as w e l l . A l t h o u g h economists usually shy away f rom anything that may invo lve personal attributes, Scherer (1980) suggests that certain social structures may be more conducive to col lus ive behavior. F o r example, participants may belong to the same social setting, and social st igma may attach to anybody that appears to be deviat ing f rom industry norms. Spence (1978) has offered a model that examines a weaker fo rm o f tacit co l lus ion w h i c h he terms tacit coordination. T h e information required to determine whether f irms may be deviating f rom any k i n d of market-sharing or price setting agreement can be formidable. Spence has buil t a model w i th incomplete information, where f irms receive signals about one anothers' actions masked by noise (a random variable i n the model) . F i r m s choose strategies based on the signals they receive that jo in t ly move them towards the profit frontier and away f rom the less profitable Courno t -Nash equi l ibr ium. In the mode l , the scope and profitability of tacit coordination increase as the signal becomes less noisy and the less profitable the profits when being punished. T h e factors described by Scherer (1980) also ho ld true i n Spence's mode l . T o the extent f i rms can m i n i m i z e the noise or restrict the information required to moni tor one another's behavior, they w i l l be more successful i n raising profits above the non-cooperative outcome. Empirical Investigations of Noncompetitive Behavior M a n y o f these factors may be quantified to test for col lus ive behavior. T h i s approach, first pioneered by B a i n (1956) and k n o w n generally as the Structure-Conduct-Performance ( S C P ) 7 4 paradigm, emphasizes variables such as the number and relative size o f industry participants to investigate the competitiveness o f markets as w e l l as re ly ing o n extensive market studies. Measures o f noncompetit ive behavior usually examine the premise that col lus ive behavior w i l l raise f i rms ' profits relative to more competit ive outcomes. M u c h research has been a imed at examining what factors may affect h o w firms conduct their business and the resulting impact o n the competitiveness o f the market. A s pointed out above, since the presumed goal o f non-competit ive behavior is to raise profits above competit ive levels , the most direct approach w o u l d be to measure profits directly as a test o f competi t ive behavior. However , there are a number o f empir ica l problems associated wi th using pub l i c ly reported profit statements, such as differences between accounting requirements and theoretical constructions o f what profits consist of, ma in ly having to do wi th the appropriate treatment o f capital . Despite this diff iculty, there is a considerable amount o f w o r k i n this area. Another approach is to s imply examine price levels , under the assumption that, ceteris paribus, f i rms use higher prices to obtain higher profits. The 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 col lus ive behavior and are usually available. A n example o f such work is W e i s s et. a l . (1989), w h i c h shows how concentration wi th in regional markets leads to higher prices i n the cement industry. There is a potentially tautological question that has to be addressed i n framing these types o f investigations. G i v e n that the m a i n objective o f co l lus ion is to lessen competi t ion, thereby leading to higher profits, does that mean that higher profits mean col lus ion? Demsetz (1968) has made the point that more successful firms w o u l d tend to have higher market shares than less successful firms, therefore leading to a correlation between market shares and profits. There may be other factors that support higher profits, such as successful technological innovat ion at the firm l eve l , w h i c h i n turn may be correlated wi th firm size. Therefore, higher profits i n and o f themselves may not necessarily be indicative o f non-competit ive behavior. 7 5 Anothe r diff icul ty wi th these approaches is that the tests require some benchmarks for co l lus ive behavior. Because the data tends to be aggregated, these measures are usually either cross-sectional across industries, or on a t ime series bas is . 8 2 E a c h o f these approaches raises its o w n set o f problems. Aggrega t ion requires that a l l firms respond i n the same manner, wh i l e cross-industry and t ime series comparisons require that the data be adjusted for any industry differences that may not be due to market power . 8 3 M u c h o f this w o r k provides litt le i f any institutional detail , and often provides no mechanisms by w h i c h non-competi t ive outcomes are sustained. A n approach that has become increasingly popular has been to note that i f firms are engaged i n competit ive behavior then price w i l l be greater than marginal cost. E c o n o m i c theory can then be used to relate the difference to the underlying demand or supply elasticity and market power (Diewert 1971). T h i s research offers the advantage o f not hav ing to rely o n comparisons across different industries but instead looks for deviations between marginal cost and price i n what is 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 how i n an o l igopoly firms w i l l set the price equal to the marginal cost plus a factor representing their perception o f how their actions affect market quantities. T h i s perception is based o n their expectations o f how other firms w i l l react to changes i n the firm's o w n actions, and the factor is commonly termed the conjectural variation. It can be shown that this factor, or 0, is bounded between 0 and 1, and under the competi t ive market assumption o f price taking 0=0, w h i l e under a pure monopoly 0=1. Tests for the exercise o f market power then consist o f whether or not 0 is significantly different f rom zero. Because much industry data tends to be national in scope, which masks regional variations, comparisons are then made across industries which typically requires adjusting the data to account for differences between industries. For example, price-cost margins are a common 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 on cash manufacturing costs, and any comparisons may yie ld 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 condit ions. Bresnahan (1981), i n his w o r k o n the automobile industry, used a H o t e l l i n g framework to model product differentiation. T h e derivation o f 6 i n this case has a component due to how different the product is f rom other f i rms ' products, w h i c h is direct ly analogous to spatial differentiation. M u r r a y (1996) used this framework to derive a 6 that is expl ic i t ly due to spatial distances, and tested for market power i n sawlog and p u l p w o o d markets i n the U S for the per iod 1958 to 1988. M u r r a y finds that al though the nu l l hypothesis cannot be rejected for sawlog markets, it is rejected for three o f the five periods examined for the pu lpwood market. Bernstein (1992) provided a s imi lar examinat ion for the forest industry i n Canada, and rejects the hypothesis that there has been any noncompeti t ive behavior i n the forest industry i n Canada i n either input or output markets. T h i s approach has its o w n set o f problems. The main benefit o f this approach comes f rom the fact that by embedding 6 i n a system of equations developed under the standard theoretical assumptions governing factor demand, the efficiency o f the estimates are thereby increased, wh i l e the incorporated factor meets the consistency properties associated wi th such demand equations (convexity and homogeneity) . There are, however , several problems w i t h the estimation o f marginal cost. T h e first is that the detailed data required for such estimation is usually available only on an aggregated basis. A l t h o u g h the difficulties o f data aggregation can be theoretically handled (usually by assuming a l l f i rms are the same), firm leve l differences are w i p e d out. M i s -specification may lead to inaccurate estimation. A s a case i n point, M u r r a y (1996) provides a s imple example of a spatial monopsonist to show how distance can 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 should br ing f i rms into increasing contact as their woodsheds expand, thereby leading to increasing competi t ion. A closer examination o f M u r r a y ' s result shows that 6 was at its highest point i n the per iod 1958-62, and then subsequently fe l l i n each succeeding four year period wi th the two lowest estimates 77 cover ing 1973-77 and 1978-82, when 6 is not statistically distinguishable f rom 0. H i s measure o f market power then rose again i n the last measured period to a l eve 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 power reflects the increasing and then dec l in ing use o f w o o d chips, arguing that pulp m i l l s enjoy less power i n p r i c ing w o o d chips than they do pu lpwood . Howeve r , there is a m u c h more plausible explanation w h i c h l ies i n the treatment o f capital stocks. M u r r a y treats the capital stock as an exogenous variable. Furthermore, instead o f using actual capacity, M u r r a y uses annual product ion. A potential problem then lies i n the fact that the only place capacity (actual production) enters directly into the estimation is i n the construction o f the market power measure (as it i s a quadratic measure o f capacity). Therefore, M u r r a y ' s measure o f market power may s imply be reflecting the correlation between h igh rates o f product ion associated wi th h igh market prices, rather than the exercise o f market power. T h i s seems especially plausible g iven that M u r r a y finds that market power 'vanishes ' dur ing the periods o f market recession. Bresnahan and Sus low (1989) provide another explanation as to w h y measures o f market power based on output or capacity ut i l izat ion may produce spurious results. T h e y examined the a luminum market i n the Un i t ed States, and hypothesized that i n the short run f i rms face constant marginal costs unti l practical capacity is reached, provid ing a backward-facing L-shaped supply curve (see Figure 9). Unde r this hypothesis, when capacity constraints are slack for the demand curve Ds, market power is greatest and the f i r m sets a price i n excess o f marginal cost, where Ps>C. W h e n capacity constraints b ind under demand conditions Dc, and the f i r m wishes to operate at m a x i m u m capacity, there is no difference between the price the f i r m w o u l d choose versus the competi t ive price, Pc. T h e capacity constraint is then reflected i n the opportunity cost o f capital (which is the equivalent o f the forgone production, or the difference between the intersection o f the demand curve, Pc, and the constant marginal costs o f product ion, C). T h e y 78 Figure 9. Pricing with and without capacity constraints from Bresnahan and S u s l o w (1989) 79 then estimate two cost functions, one under slack conditions and one operating under the assumption o f capacity constraints and show that market power, greatest dur ing periods o f slack demand, has been fa l l ing over t ime (they examined a thirty year period). These results suggest that improper specification o f the cost curve may lead to an overestimation o f market power i f the formulat ion o f the problem does not take into account the effects o f possible capacity constraints. These type o f marginal cost curves are usually associated wi th capital-intensive industries, w h i c h i n turn tend to be those industries where there are relat ively few firms. T h i s then suggests that one should be extremely careful i n using measures o f output, capacity ut i l izat ion, or concentration ratios i n constructing measures o f market power. M u r r a y ' s results m a y s imply reflect the influence o f capacity constraints and not market power, g iven that the profit function estimated does not distinguish between periods where capacity constraints may be a factor (which is a characteristic feature o f the pulp and paper industry). T h i s may offer an alternative explanation as to w h y M u r r a y ' s measures o f market power fa l l to near insignif icance during the recessionary periods o f the 1970's and 1980's as capacity constraints were not b inding dur ing those periods. M u r r a y also finds his measure o f market power to be s ignif icantly less i n the sawlog market. It may be the case that this s imply reflects the fact that the s awmi l l industry is less capital intensive than the pulp and paper industry and that capacity constraints are not a factor. A l o n g the same lines, Bernstein (1992) provides an interesting contrast, hav ing estimated a s imi la r mode l for a Canadian data set. H i s approach is somewhat different i n that he a l lows firms to have face adjustment costs for quasi-fixed factors so that short-run marginal costs may exceed long-run marginal costs. Under such circumstances, f i rms w i l l not be i n long-run equ i l ib r ium, and the fact that prices exceed long-run marginal costs reflects not the exercise o f market power but rather the presence o f these adjustment costs. Bernstein finds no evidence o f market power i n either the so l id w o o d or pulp and paper industry i n either output or input markets, but that each industry is characterized by substantial capital adjustment costs. A g a i n , Bernstein relies on annual data at the national leve l . 80 Hunter (1982) analyzed pu lpwood stumpage and del ivered prices i n the Southeastern U S and shows that pu lpwood stumpage prices are posi t ively correlated wi th the number o f bidders w i th in 100 mi les , and notes that a l l prices generally decrease m o v i n g inland f rom the At lan t i c Coast. A l t h o u g h he included the number o f bidders as indicat ive o f competi t ive pressures, he also noted that the number o f potential bidders m a y be a proxy for distance. Hunter d id not make any attempt to analyze potential competi t ive pressures, and v iewed the decrease i n price levels as one moves in land representing general changes i n species avai labi l i ty and land use patterns. A n alternative hypothesis cou ld be that transportation costs increase as one moves in land (due to the higher costs associated w i t h t rucking and ra i l relative to ocean transport), w h i c h lowers the number o f potential buyers and effectively decreases competi t ion. F ina l ly , there is a m u c h smaller set o f cases where the circumstances have lent themselves to more detailed analysis, and the impact o f changes i n the regulatory environment can be quantified. A s c h et a l . (1992) provide an examination o f the dairy industry wi th a clear change i n government po l icy , and use the price differential between two classes o f m i l k as a measure o f col lus ive behavior to show the impact o f the change on f i rm behaviour. Fraas and Greer (1977) used a number o f cases where the Federal Trade C o m m i s s i o n ( F T C ) investigated non-competi t ive behavior (as defined by formal investigations) to measure factors other than concentration ratios that were important i n supporting col lus ive outcomes. Studies of Spatial Price Discrimination E m p i r i c a l studies o f spatial price discr iminat ion suffer f rom many o f the difficulties outl ined above. Data tends to be aggregated, requir ing comparisons across regions and industries that may not incorporate a l l factors. M u c h o f the work has rel ied on results f rom simple models o f spatial monopolies to argue that any deviat ion between prices and marginal cost plus transportation costs represents the exercise o f market power. T h e magnitude o f the deviat ion is then used to quantify the degree o f market power. H w a n g (1979) provides an example o f this approach, us ing the 81 difference between delivered prices and actual transportation costs i n the pr ic ing o f coal i n the U S to measure the degree o f market power i n various markets. Greenhut et a l . (1980) and Greenhut et a l . (1981) provide empir ica l investigations o f spatial pr ic ing policies and test factors outlined earlier thought to be important i n determining the competitiveness o f spatial markets (such as locat ion, the number of competitors, and the nature of demand). These results suggest that F O B pr ic ing is the exception rather than the rule, and that relative competit ion is the most important factor i n expla ining spatial prices (Greenhut et a l . 1980). Greenhut et a l . (1981) also show that there are significant differences i n how f i rms set spatial prices between the U S , W e s t Germany , and Japan, and that price discr iminat ion is more prevalent i n the latter two countries. T h e y also show that i n Japan and Wes t Germany delivered prices sometimes significantly decrease wi th distance, although this pattern is never observed i n the U S , and attribute the fact that the U S has antitrust laws that forbid f i rms to charge less to more distant customers . 8 4 Summary These sets o f models and studies show that spatial price discr iminat ion appears to be pervasive. H o w e v e r , a weakness o f Greenhut et a l (1980) and Greenhut et al (1981) is that their work relies on questionnaires to ask firms to rank the relative competitiveness o f their markets. T h e y also use f irms i n different industries without adjusting for industry differences, making it difficult to quantify the amount o f competi t ion and relate a specific market structure to a particular type o f spatial p r ic ing . T h i s ambigui ty also appeared i n the models studied throughout this chapter, where i t was shown that no definit ive conclusions could be drawn f rom the presence o f discr iminatory pr ic ing . T h i s then leaves the basic question unanswered: T o what extent does price 8 4 The Robinson-Patman Statute under the Clayton A c t in the U S restricts firms from setting different prices to the extent such discounts do not reflect differences i n production costs. The Competi t ion 8 2 discr iminat ion represent the exercise o f market power, or s imply competi t ive behavior g iven the market structure? In order to answer the question, i t is necessary to develop a model that accurately characterizes the market i n question. A c t in Canada does not circumscribe spatial pricing so narrowly (see Director of 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 Ohta 1993:399) T h i s chapter discusses the general economics o f product ion and the special circumstances that apply to residual w o o d ch ip product ion. It also examines supply curves for w o o d chips i n B C to the extent they have been identified, and how transportation costs may affect p r ic ing for pulp f ibre. F ina l ly , a specific mode l is developed for the w o o d chip market that incorporates the salient features o f w o o d chip product ion 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 technology governing the product ion o f goods may take one o f two forms. Goods may either be produced s ingly or as j o in t products, when two or more goods are produced simultaneously. A n example 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 pu lpwood , mak ing i t straightforward to identify both the marginal and average costs o f product ion. W h e n pu lpwood is produced jo in t l y a long w i t h saw logs, neither the average costs nor marginal costs can be identified since it is impossible to attribute a l l costs to a specific product. There are two types o f jo in t production based o n the production process: technical ly f ixed proportions or technical ly variable proportions. I n the case o f f ixed proportions, the relative proportions o f pu lpwood and sawlogs are exogenously f ixed . N o matter at what level or relative proport ion the inputs are applied, every stand harvested w i l l y i e ld , for example, 2 0 % pulp logs and 8 0 % saw logs. Nei ther the leve l o f harvesting intensity, the ut i l izat ion o f the tree, nor the design o f the s a w m i l l , can change that ratio. 84 In the case o f technical ly variable proportions, the ratio o f the two products can be varied. One can imagine harvesting f ive hectares wi th the overal l output vary ing by the effort employed on that f ive hectares, but also w i th the relative proportion o f each output va ry ing i n response to the demand for the two products. Substitution between the two outputs may lead to greater production o f one at the expense o f the other, or mean that the effort is redeployed towards producing more o f one product. F o r example , i n harvesting a stand o f trees, relat ively h igh prices for pulp fibre might mean that w o o d suitable for l o w -grade lumber w o u l d be chipped instead o f sawed wh i l e smal l l imbs and treetops previously left behind as l ogg ing debris w o u l d now be brought i n to be chipped. T h e importance o f both o f these cases is that although the marginal cost can be identified, g iven a prespecified l eve l o f production, the average cost o f either output cannot because o f the nature o f the jo in t production. A more practical problem is that the different types o f supply offer different b inding constraints; for example, i n the case o f technical ly f ixed proportions, increasing the product ion o f one product requires increasing the product ion o f the other. F o r technical ly variable proportions, i t may be possible to make adjustments i n product m i x without increasing overa l l production. That is , the relative proportions o f lumber to chips may be varied without changing l o g consumption. Sources of Heterogeneity in Wood Chips T h e goal o f w o o d chip production is to produce a uni form series o f rectangular pieces o f the same thickness. Because o f the nature o f the product ion process, irregular and oversize pieces w i l l be produced as w e l l . T h e 1970s saw the introduction o f the K a m y r continuous digester (the cook ing vessel i n w h i c h w o o d fibre is broken d o w n into pulp) replacing the batch digesters used before. T h i s i n turn required more consistency i n the w o o d chips, as variations i n the size o f chips affected the y i e ld . Previous ly , i t was possible to adjust the cook ing conditions for each ind iv idua l batch. Recent ly , many pulp m i l l s have introduced pr ic ing systems designed to encourage the production o f certain chip sizes and penalize those that fa l l outside what are considered acceptable ranges. A s a consequence, whi le residual chips appear to have varied wide ly i n the early stages o f the development o f the industry, such differences had vanished by the late 1980's. T h e m a i n differences between w o o d chips now l ie i n the species f rom w h i c h they are derived. A s noted earlier, the predominant lumber m i l l e d i n the Interior is spruce, pine, and fir, or S P F , and consequently the bulk o f chips produced i n the Interior are S P F chips. However , there are significant amounts o f Douglas-f i r , cedar, and hemlock i n certain areas. The greatest difference between these tend to be process specific; for example, a T M P m i l l w i l l prefer to use spruce, completely avo id Douglas-f ir , and keep the pine content below certain levels, due to some o f the extractives present i n the latter two woods w h i c h affect the quali ty o f the pulp. Cedar , because of its lower density and darker color , requires additional bleaching and takes up more digester space relative to the denser whi tewoods and consequently sells at a discount to the whi tewoods (Gaston et al 1995). H e m l o c k is a desirable whi tewood, being naturally bright, but occurs i n l imi t ed stands i n the Interior but is c o m m o n on the Coast. The most c o m m o n problem associated wi th hemlock tends to be the fact that it may contain h igh amounts o f decadent w o o d wi th the associated rot w h i c h needs to be screened out. Equilibrium with Joint Production In competi t ive product and factor markets a l l prices are simultaneously determined such that a s a w m i l l producing both lumber and w o o d chips earns normal profits. In equ i l ib r ium, profit maximiza t ion means that the marginal value o f each product equals the price o f the input (alternatively, the ratio of the output prices equals the ratio o f the marginal costs i n terms o f the input). In terms o f the inputs, i t is c o m m o n to assume that most inputs are perfectly elastically suppl ied . 8 5 Hence a l l inputs w o u l d also be earning normal economic returns, wi th any excess returns attributed to any input that is fixed i n nature. In the This simply means that any quantity of the input can be obtained at a given price. context o f the forest industry, i t is standard to assume that any excess returns after the returns to capital are calculated can be attributed to the other f ixed factor wh ich is the resource itself. T h i s is c o m m o n l y cal led economic rent and is the payment i n excess o f that necessary to bring that factor into production. In the s imple case o f harvesting a homogenous stand o f trees, the economic rent w o u l d consist o f the value o f those trees derived f rom the products they could produce, less the cost o f producing those products and harvesting the trees ( including a normal return to capital). T h e rent cou ld be nonexistent i f the value o f those trees just equaled the cost o f harvesting them and convert ing them into f inal outputs. T h e goal o f government po l i cy is to col lect this rent through charges for the access to publ ic t imber or stumpage (commonly defined as the price paid for standing timber). In order to calculate the possible rent, then, it is necessary to k n o w both the value o f products derived f rom a tree and the costs o f producing those products ( inc luding harvesting). A s outl ined 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 jo in t production. T h e issue o f the appropriate level o f rent capture has been of major importance i n the B C forest industry for m u c h o f the last two decades (Schwindt and Heaps , 1996). Because an appraisal system is used to determine charges for C r o w n t imber i n B C , the complex interaction between jo in t production, coupled wi th substantially different end markets, wi th one good an intermediate good and the other a final good, make administering such a system extremely difficult . A s Ander son (1980) points out, the potential exercise o f market power i n timber markets due to the prevalence o f regional monopol ies c o m m o n to the forest industry on ly adds to the diff icul ty i n ensuring that any stumpage system based on 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 should be noted that because o f the technology, the price of a product may have no bearing on the level o f production at certain prices. Fo r example, a firm may find that i n producing so l id lumber a certain port ion o f the l o g w i l l end up as waste, either as sawdust or w o o d chips, and that port ion cannot be m i n i m i z e d beyond a certain amount. T h e firm w i l l max imize profits by setting the marginal revenue product o f its input (assumed to be logs) equal to the price o f the output, w h i c h w o u l d equal the value o f the so l id w o o d and w o o d chips and sawdust that l og cou ld produce. I f there were disposal costs associated wi th any o f the residual by-products, these w o u l d be subtracted f rom the output price. In this case, then, there is no tradeoff between the two products, and the firm's profits are m a x i m i z e d where the marginal cost o f production equals the price o f a l l the outputs. Because residual w o o d chips are a consequence o f lumber production, posi t ive quantities w i l l be produced even i f the market price for w o o d chips is zero or negative (that is , there are disposal costs) so long as the net output price exceeds the costs o f production. No t i ce that an increase i n the lumber price may cause overal l production o f lumber and hence w o o d chips to increase, even i f there is no change i n demand for w o o d chips. Al te rna t ive ly , at l o w enough lumber and chip prices, a s a w m i l l may choose to shut down , causing the production o f both to cease. In this example, the quantity demanded o f w o o d chips is less than the quantity supplied (or may even be nonexistent). T h e nature o f the technology is such that positive quantities o f residual w o o d chips are produced even i n the presence o f market signals (non-positive prices) that w o u l d lead to a reduction i n production under other supply condit ions. However , i f the demand for w o o d chips increases to the degree that the sawmi l l perceives i t is worth processing additional t imber given current costs, then even i n the case o f technical ly fixed proportions, the output o f residual w o o d chips w i l l increase (as however w o u l d the production o f lumber) . In the case o f technical ly variable proportions, relative output prices w i l l determine relative output proportions. In the case o f a smoothly continuous technology, non-posit ive w o o d chip prices (and posit ive lumber prices) w o u l d mean no residual w o o d chips w o u l d be produced. Posi t ive demand i n this case w o u l d lead to posit ive prices for and product ion o f w o o d chips. In this case, the margina l cost o f w o o d chips could be the cost o f the so l id w o o d forgone at the expense o f w o o d ch ip product ion. F o r w o o d chips there are several possibil i t ies i n terms o f supply, each w i t h impl ica t ions for how prices are determined. T h e first possibi l i ty is that w o o d chips are the sole product, and the price w i l l equal the marginal cost o f production. T h e second possibi l i ty is that they are a jo in t product, i n w h i c h case the technology may be such that w o o d chips are produced i n excess o f the perceived demand and prices may be zero or even negative. A t this point i t is instructive to examine the actual mechanics o f w o o d chip production i n the Interior o f B C . W o o d ch ip product ion i n the Interior consists o f two types o f supply, roundwood chips and residual chips. R o u n d w o o d (or pulp log) ch ip product ion can be thought o f as the single product type o f supply and consequently a l l the costs associated w i t h roundwood chips can be easily ident i f ied . 8 6 Res idual chips are j o in t l y produced along wi th lumber, and i t is imposs ible to clear ly identify the costs o f product ion o f w o o d chips by themselves. W h i l e some costs such as convey ing systems, storage bins, or ch ip handl ing can be directly attributed to the product ion o f chips, overal l costs o f product ion cannot. r Furthermore, the jo in t production is o f the technical ly variable type over certain ranges o f lumber and chip values, since l o w grade lumber can potentially be chipped depending o n the relative prices (Nelson et a l 1994). This 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 involved in 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 more valuable than w o o d chips i n the past, and sawmil lers have tended to max imize lumber production. A s a consequence, the production of chips has been m i n i m i z e d and w o o d chip production wi th in the region appears to have been closely related to i f not proportional to lumber production. Table 8 shows estimates o f the ch ip recovery factor for different regions wi th in the Interior for the past ten years, where the recovery factor is expressed as the amount o f B D U s produced per cubic metre o f l o g input. Table 8. Estimated chip recovery factors in the BC Interior 1987-1995 (BDU s per cubic metre of log in put) Reg ion 1986 1987 1990 1993 1995 Car iboo .15 .16 .15 .16 .16 K a m l o o p s .12 .13 .16 .14 .14 N e l s o n .14 .14 .14 .13 .15 Pr ince George .14 .14 .14 .14 .14 Pr ince Rupert Coast * .18 .16 .18 .15 .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 chips relative to poorer grades o f lumber has meant that at times some sawmil l s have chipped what w o u l d otherwise be termed ut i l i ty grade lumber. T h i s can either take the form o f chipping a smal l poor quality l og that w o u l d have only y ie lded uti l i ty lumber or chipping the util i ty lumber after i t has been sawn (the latter w o u l d take place i f the s awmi l l d i d not have a whole l o g chipper). T h e trend appears to be a continued emphasis on lumber production w i t h some small scope for minor increases i n chip production through changes i n their opt imizat ion when prices warrant it . T h i s suggests that the appropriate supply curve for w o o d chips i n the Interior is relat ively inelastic, although there is the possibi l i ty that a reservation price for chips (a m i n i m u m price sawmil l s must receive) may set a price f loor. T h i s reservation price w o u l d be negatively related to the price o f lumber as discussed i n the preceding section, and w o u l d create an L-shaped supply c u r v e . 8 7 Figure 10 illustrates such a supply curve, where the horizontal port ion is established by the reservation price, P w c l . I f the s awmi l l receives a price equal or greater than this price it w i l l produce the fixed quantity Q l . A higher price for lumber lowers the horizontal part o f the L-shaped supply curve to P w c 2 but has a more ambiguous effect on the vertical port ion o f the supply curve. T h e higher price might shift ch ip product ion inward through minor changes i n op t imiz ing behaviour, but higher lumber prices cou ld also increase lumber production and hence chip production i f higher prices increased the amount o f t imber that cou ld be harvested or purchased. I f the a l lowable cut was a b ind ing constraint, however, a drop i n a l lowable cut f rom A A C 1 to A A C 2 w o u l d shift the vert ical portion o f the supply curve for chips inward and reduce supply to Q 2 . Changes i n technology that improved lumber recovery relative to chip recovery w o u l d also have the effect o f shifting the vert ical port ion o f the supply curve inwards . 8 8 Unfortunately, there does not exist the data to support a rigorous examinat ion o f the sensitivity o f chip product ion to changes i n prices, technology, harvesting practices, or l o g sizes. Howeve r , it is possible to construct a p roxy for ch ip recovery factors to see whether the assumption o f inelastic behaviour is unrealistic. Figure 11 shows chips produced ( in B D U s ) per thousand board feet o f lumber produced by forest region for the Interior and B C C o a s t . 8 9 G i v e n that sawmi l l s w i l l try to m i n i m i z e sawdust and hog fuel production, for w h i c h they either receive nomina l revenues or incur posit ive disposal costs, one can assume that an increase i n chips produced per thousand board feet (Mfbm) comes at the 8 7 The N A P A P model used by the Canadian Forest Service to model the North American pulp and paper industry assumes residual chip production in Western Canada is h ighly inelastic and perfectly inelastic in the Western U S (Catimel, 1996). 8 8 This assumes that the effect of fixed costs being spread across lower production levels and raising average total costs can be ignored. 8 9 Proxies for chip recovery were constructed by taking monthly chip production by region and d iv id ing 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 Pwd Pwc2 P11 PI2>PI1 y f Q Q 2 Q 1 AAC2 < 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 lumber produced. Therefore, the amount o f B D U s per M f b m then serves as a p roxy for the ch ip recovery factor for sawmi l l s , and should show how the price o f lumber and the price o f chips may influence ch ip production. 0.900 0.800 0.700 E 0.600 e 0.500 mm 0.400 a a 0.300 0.200 0.100 0.000 F igure 1 1 . Chip R e c o v e r y by Reg ion 1 9 9 3 -1 9 9 5 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 Jan-93 Jun-93 Nov-93 Apr-94 Sep-94 Feb-95 Jul-95 Dec-95 • Southern -ffl— Northern -A— Central -X—Coast Table 9 shows the correlation between the above measure o f chip recovery 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 (BDU/Mfbm) Northern (BDU/Mfbm) Central (BDU/Mfbm) Std& Btr ($Mfbm) Utility ($Mfbm) Economy Chip ($Mfbm) ($/BDU) Southern(BDU/Mfbm) 1 Northern(BDU/Mfbm) .40 1 Central (BDU/Mfbm) .39 .60 1 Std & Btr($Mfbm) -.25 -.45 -.72 1 Utility($Mfbm) -.15 -.44 -.72 .91 1 Economy($Mfbm) -.22 -.05 • -.54 .47 .45 1 Chip ($/BDU) .19 .21 .74 -.56 -.71 -.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 lumber prices are negatively correlated wi th chip recovery; as lumber prices increase, ch ip recovery declines as sawmil ls increase lumber recovery. T h e correlation between chip recoveries and their o w n price is quite l o w for the northern and southern regions, as w o u l d be expected w i t h an inelastic supply curve. Surpr is ingly enough, however, the central region (corresponding to the C a r i b o o Forest Reg ion) , showed a m u c h higher correlation between the chip recovery proxies and lumber and chip prices. T h i s m a y reflect the fact that the central region is the smallest region i n terms o f chip production and the results may reflect more uniformity o f f irms w i t h i n this area or the development o f roundwood ch ipp ing capacities by sawmi l l s w i th in the region. These results, however , are on ly suggestive. M o r e rigorous analysis w o u l d require data on l og inputs on a monthly basis as w e l l as a more detailed description o f the sawmi l l s wi th in each region (as ch ip recovery varies by the type o f product produced, the size and species o f logs sawn, and s a w m i l l configuration). In addi t ion, the per iod above covers significant changes i n price levels for w o o d chips that may affect the apparent results; as w e l l , some o f the reported chip production may include roundwood chips. T h i s i n turn w o u l d raise the apparent chip recovery factor and w o u l d also affect the apparent responsiveness to changes i n the ch ip price. Integrating Demand and Supply In order to integrate demand and supply, i t is necessary to incorporate transportation costs. Sawmi l l s tend to be located near their harvesting areas to m i n i m i z e log-haul ing costs and, as a consequence, are dispersed throughout the Inter ior . 9 0 Pu lp companies 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 in discarding a portion of the material, the firm w i l l weigh the benefits of processing as close to the site as possible to minimize the transport of what w i l l be waste material after processing. There is an added cost of being further away from its final markets, however. 94 costs to their final market. A s noted earlier, their large raw material needs tend to l i m i t the potential number o f pulp m i l l s i n an area; however, the transportation network i n the Interior l imi t s the number o f possible locations and has an opposite effect. Because w o o d chips are bu lky , transportation costs are relat ively h igh per unit. Therefore, transportation costs can be significant when evaluating alternative markets for w o o d chips. Current transportation costs today range f rom approximately 10-20 cents per B D U per ki lometer for trucks, and 7 cents per k i lometer by ra i l when f ixed loading and unloading charges are ignored. Based on interviews wi th industry participants, average transportation costs i n the Interior range f rom $12 to $25 per B D U , depending o n distances and haul roads ( K u a n 1997, E d g s o n 1995, Pinette 1995). These costs appear to have remained unchanged for the past several years . 9 1 A Model of Price Discrimination in a Wood Chip Market The model developed by Geldhart and Car ro l l (1980) to examine the A lbe r t a w o o d chip market can be used to illustrate the relationship between price levels, pr ice patterns, and competi t ive markets. F i g u r e 12 illustrates what a supply curve w o u l d l ook l ike when a pulp m i l l receives w o o d chips f rom sawmil ls that l ie increasingly distant and the quantity purchased varies directly w i t h distance. T h e pulp m i l l , located at O , purchases chips that are supplied inelastically by a number o f sawmil ls that l ie along the l ine O E . E a c h sawmi l l is identical and has a reservation price or supply price, O A , that must be met before it w i l l sel l its chips. In addit ion, there are posi t ive transportation costs, t, that increase directly wi th distance. Under these conditions the supply curve is A S , and the competi t ive price at the pulp m i l l gate is established by the intersection o f the demand curve (D) w i th the supply \\ curve ( A S ) . S a w m i l l E is the marginal supplier and receives E D , exactly equal its reservation price, wh i l e the total quantity purchased is O E . In this case, the pulp m i l l pays 9 1 A contract between a trucking company and sawmill in the Interior dated 1987 works out to a rate of . 15 per B D U per kilometer, based on a fuel cost o f 39 cents per litre (now 50 cents for diesel) ( D C T Chambers 1987). 95 the same del ivered cost for a l l chips, O B , regardless o f where they originate. E a c h s awmi l l then receives a different net price, B D , based o n the transportation costs f rom their locat ion to the pulp m i l l , w i th the net price fa l l ing for more distant sawmil l s due to their higher transportation costs ( sawmi l l A receives the fu l l pr ice O B ) . In this case, there is no price discriminat ion, as the pulp m i l l pays the same price delivered to the pulp m i l l gate for a l l chips regardless o f where they originate. Unde r conditions o f no price discr iminat ion, then, the most l i k e l y explanation for the be l ief that prices are too l o w or uncompeti t ively l o w is that not a l l the costs associated wi th ch ip product ion have been identif ied. A s s u m i n g the supply price o f sawmi l l s does not take into account the alternative o f having to incur disposal costs, i t is easy to see w h y there may be a perception that prices are \"too l o w \" . E v e n i f the pulp m i l l is paying the same price delivered at the pulp m i l l gate to a l l sawmil ls , satisfying the competitiveness condi t ion, there may be sawmil l s for w h i c h the net price does not cover their direct costs. A s an example, imagine the pulp m i l l is paying $ 4 0 / B D U delivered, wh i l e the s awmi 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 los ing $ 5 / B D U . Howeve r , the costs o f disposing o f unprocessed residue is $ 1 0 / B D U , so the s a w m i l l is actually m a k i n g a surplus o f $ 5 / B D U by producing and sel l ing the chips to the pulp m i l l . 9 2 In the above example the purchaser pa id the same delivered price to the pulp m i l l gate for a l l chips w h i l e the suppliers took care o f transportation. If, however, the pulp m i l l take into account the effect it has on market prices by constructing a marginal expenditure curve (not pictured), it cou ld restrict its purchases and thereby lower prices, increasing profits. Marke t power w o u l d i n this case be expressed as a reduction i n the price be low O B , and the quantity purchased w o u l d correspondingly f a l l . However , there w o u l d st i l l be no price 'There were producers who, for one reason or another, were not signed up to sell their chips to Interior pulp mil ls and i f they wanted to dispose of them it was costing $8 to $10 a bone dry unit -about 2 1/2 tons - to put them into landfi l l or burn them.\" Globe and Mail, September 22, 1979 96 discr iminat ion as sawmil l s wou ld st i l l receive different net prices based on the transportation costs for their locat ion. Pr ice discr iminat ion is practiced when the purchaser pays each supplier the same price at the s awmi l l gate, as i n Figure 12. T h e purchaser now pays each ind iv idua l supplier O A , w i th the delivered cost equaling A S , the supply curve. Unde r such a p r i c ing arrangement, sawmil l s are unable to derive a surplus f rom their locat ion, and the f i rm is pract icing discriminatory p r i c ing by effectively paying more for distant w o o d chips, even though the value o f the chips are identical once delivered to the pulp m i l l . T h e buyer captures the surplus by pay ing the sawmil l ' s supply price and assuming the transportation costs. Note that the most distant s awmi l l supplying the pulp m i l l , E , is st i l l located at the intersection o f the demand and supply curves, and the amount purchased, O E , is unchanged f rom the competi t ive solution. 1 2 0 1 1 0 1 0 0 a m 9 0 -% 4* 8 0 7 0 6 0 Figure 1 3 . Sawmi l l and D e l i v e r e d Pr ices f o r D i f f e r e n t Sawmi l l s and Pulp mi l l s in t h e I n t e r i o r f o r t h e T h i r d Q u a r t e r o f 1 9 8 9 5 0 1 0 0 k i l o m e t r e s 1 5 0 —Del ivered Price -X—Sawmil l Price 2 0 0 T h e data shown i n Figure 13 and Figure 14 show the pr ice for w o o d chips at the sawmi l l gate and an imputed delivered price to the pulp m i l l . 9 3 These figures suggest that a 9 3 Transportation costs of 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 in F i g u r e 13 and thirteen different transactions in F i g u r e 14, consisting o f three different purchasers and seven different sawmills). 97 discriminatory pr ic ing 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 rom the pulp m i l l , sawmil l s tend to receive s imi lar prices for their wood chips. Does this mean that purchasers are exercising their market power and that the market for chips is not competit ive? F i g u r e 1 4 . S a w m i l l and D e l i v e r e d P r i c e s f o r D i f f e r e n t S a w m i l l s and Pu lp Mi l l s in t h e I n te r i o r f o r t h e T h i r d Q u a r t e r o f 1 9 9 0 1 0 0 k i l o m e t r e s Delivered Price •Sawmill Price 2 0 0 The models and empir ica l work i n the preceding chapter showed that lack o f competi t ion may or may not lead to price discriminat ion. T h e ambiguous results reflect differences i n market structure and assumptions about f i r m behavior. Therefore, i n order to examine to what extent market power may be a factor i n expla in ing prices observed i n the Interior, it is necessary to use a mode l that accurately captures the characteristics o f the Interior market. T h e previous chapter showed that there is no shortage o f models i n game theory. One o f the reasons for such an embarrassment o f riches is that many models are developed to investigate specific questions, such as how a particular market structure may influence outcomes. Consequently, the large number o f models reflects the complexi ty o f the economic environment and the modeler 's need to s impl i fy that complexi ty by choosing those economic 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 The simple model of price discr iminat ion by Geldhart and Car ro l l (1980) y ie lded a pattern o f uni form prices across sawmi l l s regardless o f the distance between the s awmi l l and pulp m i l l . T h i s pattern appears to reflect the practice o f formula pr ic ing observed i n the Interior market. However , their mode l was based on a single purchaser, and cannot expla in w h y a particular price level may be chosen, since under condit ions o f jo in t production the costs o f ch ipp ing are not w e l l identif ied. T h i s issue becomes even more problematic as the number o f buyers increase, since each buyer w o u l d presumably choose its o w n price l eve l , and there is no 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 locat ion, the presence o f alternative buyers (whether they be other pulp m i l l s or the export market), and the avai labi l i ty o f residual chips (which w o u l d vary by region), the commonal i ty o f prices seen i n Figure 13 and Figure 14 is even more str iking (especially when compared to the prices for pulp observed i n Figure 2). Furthermore, the mode l does not expla in why prices increased so rapidly when pulp m i l l s started b idd ing for chips. N o n e o f the other models discussed earlier fit the Interior market any better. First , the market has been relatively static i n terms o f market structure, namely the distribution and size of purchasers over the study per iod. Therefore, i n order to answer the question o f whether the observed prices i n Figure 13 and Figure 14 reflect the exercise o f market power or s imply the influence o f competi t ive forces, it is necessary to use a mode l that examines both prices and p r ic ing patterns. In the case o f the Interior market, Chapter 1 identified several important facts regarding the Interior w o o d chip market. A s noted above, market structure i n terms o f the number o f purchasers has been static. M o s t o f the pulp m i l l s i n the Interior were completed by the early 1980's; o f the two buil t since, both rely entirely on internal sources for chips (the Fibreco M i l l i n T a y l o r by F ibreco members and the Louis iana Pacif ic M i l l i n C h e t w y n d by the purchase o f aspen pulp logs) . Reg iona l market structure varies i n one o f the two ways: either two different pulp m i l l s (that is , pulp m i l l s owned by two different companies) are found i n the same town (as i n Pr ince George, Mackenz ie , and Quesnel); or there is only one pulp m i l l w i th in a region (as i n K a m l o o p s , 99 Castlegar, and Skookumchuck) w i th alternative purchasers located at considerable distances (see again F i g u r e 3 ) . Therefore, i t is necessary to look at games that examine the interaction between different delivered pr ic ing systems and firm behavior rather than those that rely on the number o f firms. T h e m a i n approach i n mode l ing such games has been to use the H o t e l l i n g model as a starting point. T w o of the models examined i n Chapter 2 used such an approach; however, each mode l had important shortcomings. Espinosa (1992) restricted the actions a firm cou ld undertake w h i c h a priori ruled out certain outcomes. Thisse and V i v e s (1988) d id not examine the implicat ions o f repeated interaction, nor d id they examine the impl icat ions o f uni form delivered pr ic ing systems. In addition, both o f these models were concerned w i t h market power on the demand side and neither paper attempted any empir ica l tests o f the models. T h i s meant that i t was necessary to develop a mode l that captured the characteristics o f the Interior market wh i l e provid ing testable hypotheses. A mode l adapting Thisse and V i v e s (1988) a long w i t h Espinosa (1992) was used on a data set that w o u l d permit the examinat ion o f whether changes i n firm behaviour cou ld expla in the pattern o f prices observed i n the Interior w o o d chip market. T h e mode l is constructed i n two parts. T h e first part examines the non-cooperative or N a s h equi l ib r ium for duopsonies under two different market structures; one where the firms are located together, and the other where they are spatially separated. T h e mode l then shows that different pr ic ing patterns emerge as the unique N a s h equi l ib r ium based on the particular market structure. T h e second part then examines the effect o f repeated interaction. In t rying to mode l tacit col lus ion, the favored approach has been to use inf ini tely repeated o l igopoly games, or supergames. These supergames focus on the characteristics o f the environment that firms find themselves i n to see what factors may support outcomes that raise payoffs above the lowest l eve l o f non-cooperative (or competit ive) behavior. T h e diff iculty w i th such games is that they generate a number o f possible equi l ibr ia , often sustained by punishments that are never observed. The punishment c o m m o n l y 1 0 0 takes the fo rm o f a set o f prices or actions by a f i r m designed to impose sub-optimal payoffs on the other firm(s) that deviate(s)). T h e threat o f such punishment is usually sufficient i n such games to ensure that firms col lect ively adhere to a more (collect ively) profitable outcome and therefore firms w i l l never deviate i n equi l ib r ium and hence these sub-optimal outcomes are never observed. It is customary i n this type o f mode l ing to choose the most severe punishment possible to arrive at the equi l ib r ium (for example, a firm may threaten to set prices such that no firm w i l l earn a profit i n perpetuity i f any other firm deviates) . 9 4 T h i s model uti l izes the non-cooperative outcome f rom the one-shot game (that is , without repeated interaction) as the punishment i n model ing the supergame. It turns out that the basic mode l offers some powerful insights into how market power and firm locat ion can interact to produce both changes i n price levels and changes i n p r i c ing systems s imilar to those seen i n the B C Interior w o o d chip market. T h e mode l shows that the pattern o f c o m m o n prices across suppliers (sawmil ls) does not emerge under the assumption o f competi t ive behaviour, regardless o f market structure, and that this pattern can only be sustained under certain conditions. Because most models are configured w i t h firms sel l ing to spatially dispersed consumers, i t should be emphasized that the mode l below has been adapted to have firms purchasing f rom spatially dispersed suppliers. F i rms are located under two different configurations. In the first, they l i e at either end o f a l ine segment o f unit length (separate locations); i n the second, they both l ie at the same end o f the l ine segment (coincident locations). Suppliers are distributed wi th unit density over the interval X=[0,1], w i th firm 1 located at 0 and firm 2 at 1 when they are separately located, and both at 0 under coincident locations. F i r m s purchase inputs f rom their suppliers and use a Leont ief , or fixed 9 4 The difficulty with this approach is two-fold: first, different assumptions about punishment w i l l generate different equi l ibr ia and one never has an opportunity to observe any \"punishment\"; and second, the choice of punishment (as in the example) may not be plausible and appear somewhat arbitrary. 101 factor technology, to process the purchased input wi th other factors to produce outputs sold into competi t ive markets. Therefore, firms w i l l have equal and constant marginal revenue products, R j , less the cost o f other factors o f p roduc t ion . 9 5 Ini t ial ly let F i r m 1 be the l o w cost producer and F i r m 2 the h igh cost producer such that R , = R and R j = R - c w i t h c>0, w h i l e suppliers provide a homogeneous input inelastically. Note that these assumptions actually fit the Interior market quite w e l l . T h e number o f buyers is few, w i th only two buyers i n any one loca t ion (such as Pr ince George or Quesnel) , and i n many cases sawmil l s find themselves l y i n g between two buyers whi le export restrictions l i m i t the effectiveness o f the export market. In addit ion, w o o d chips are homogeneous, g iven the species. Due to their bu lky nature, and a l imi ted transportation network, transportation costs tend to be h igh relative to the value o f the product. C h i p production is fair ly continuous. Often, because o f l imi ted storage space, sawmi l l s cannot produce lumber for more than a few weeks i f they cannot get r id o f their chips. W i t h the phasing out o f beehive burners, sawmi l l s face increasing costs i f they have to dispose o f their chips, ma in ly through landf i l l ing , hence creating an inelastic supply o f chips. F i n a l l y , marginal costs tend to be constant as the proportions o f chemicals , energy, and labor used i n the manufacture o f pulp are fixed i n the short run, leading to a constant marginal revenue product for the fibre input based upon the se l l ing price o f pulp (Armst rong , 1975). Ini t ia l ly , this is a two-stage game, w h i c h means that firms may first choose to commi t to a particular p r ic ing po l i cy and then choose their prices. In this case, the two pr ic ing pol ic ies available to the purchasers are either uniform pricing ( U P ) or discriminatory pricing ( D P ) . U n d e r uni form pr ic ing , the pulp m i l l chooses to set a uni form price for residual chips del ivered to the p u l p m i l l gate, regardless o f the distance traveled. Th i s means that the net price to the sawmi l l then falls as the distance between it and the pulp m i l l purchasing the chips increases. T h i s type o f pr ic ing system is o f interest since this is what w o u l d be observed under the rationale o f the \" L a w of One Pr ice\" ; that is , the pulp m i l l pays the same for a l l chips, regardless o f where they originate. 9 S 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 of output sold for p, then R=p/2. 102 Under discriminatory pr ic ing , f irms retain their freedom to choose to compete over the entire range o f the market i n prices, resulting (as I w i l l show) i n a Nash E q u i l i b r i u m i n prices at the supplier. Discr imina t ion refers to the fact that net prices to the supplier, or alternatively, the delivered price to the mil l -gate for two goods coming f rom two different locations may vary by other than the actual transportation costs between those two points. No t i ce that this type o f p r i c ing does not restrict the f i r m to any particular type o f del ivered p r ic ing system, o f w h i c h uni form pr ic ing is a subset. In addition, f i rms anticipate the equi l ib r ium prices under the different p r ic ing systems when choosing among pr ic ing schemes. Because there may not exist a pure N a s h equi l ib r ium at the second stage when one f i r m chooses un i form pr ic ing , i t is assumed that the f i r m that chooses to price uniformly becomes the price leader wh i l e the other f i rm w i l l react opt imal ly to the first f i rm ' s prices. Unde r these assumptions, there are four possible outcomes. F i g u r e 15 shows the game tree for these outcomes, where both f i rms either both choose to price un i formly , or both choose to price discriminate, or one o f the two firms becomes the price leader by choosing to price un i fo rmly . The latter two cases lead to the p r i c ing system cal led basing-point p r i c ing ( B P P ) . Unde r these circumstances, this type o f p r ic ing arises under competi t ive behaviour. Suppose f i rms ( sawmil l s ) are situated i n different locations, and F i r m 1 chooses to price uni formly . F i r m 2 can then choose to set its price fractionally higher, or an epsi lon 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 marginal 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 pulp m i l l gate; F i r m 2 then prices discr iminator i ly such that i t pays the same net price as a supplier w o u l d receive f rom F i r m 1 ( P P ' ) . F i r m 2 w o u l d then purchase out to where the delivered cost (the net price plus the transportation cost for that supplier) w i l l just equal the marginal revenue product for F i r m 2 (R2), y ie ld ing the market 1 0 3 Figure 15. Game Tree for Firms that Either Commit to Price Uniformly (UP) or Retain Their Freedom to Price Discriminate (DP) UP Firm 1 Firm 2 N a s h in pr ices Firm 1 price leader Firm 2 price leader N a s h in price schedu les Drawn from Th isse and V ives (1989) 104 \\ Figure 16. Basing Point Pricing with Firm 1 the Price Leader 105 boundary between the two firms(BB'). It can be seen that F i r m 2 w i l l enjoy larger profits than F i r m 1 (this is shown i n the next section); consequently, no f i r m w o u l d choose to be a price leader g iven the assumption o f non-cooperative behaviour. T h e next section looks at the sub-game equi l ibr ia o f the game under each o f the two scenarios. Coincident Location W i t h coincident locat ion, Bertrand competi t ion means that the only sub-game perfect equi l ibr ium is where both firms choose uni form pr ic ing . I f c>0, then F i r m 2 w i l l be shut out o f the market and F i r m 1 w i l l price an epsi lon above R - c and 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, 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 both firms are located coincidentally. Separate Locations Under separate locations, however, both firms (pulp mi l l s ) can remain i n the market under either price system, so long as t > R - c . In this case, then, there are four possibi l i t ies , out l ined be low. Case 1. ( U P , U P ) : T h e market boundary between the two firm's area is g iven by the locat ion x of the supplier indifferent between the two net prices offered: 106 w h i c h yields: X = (A ~ Pi +t)/2t G i v e n that suppliers are distributed uni formly , profits are then g iven by: JTj = (R- p{ )x and jt2 =(R-c-p2\\l-x) U s i n g the first order condit ions, this then yie lds equ i l ib r ium prices {R-t -c/3,R-t-2c/3) respective market areas (JL I I __£\\ \\6t + 2,2~6t) and respective profits [ f£ + A (3 + cr) C — + /V3 -c / ) ^ l b r ' \\ 3 z1 | | 6 ' 6 | Case 2 . ( D P , D P ) : W h e n both f irms choose to retain their freedom to price discriminate i n the second stage, then the equi l ib r ium price schedule is : p*(x) = min { R-c-t(l-x), R-tx } w i t h x between [0,1] as Bertrand compet i t ion drives prices up to the lowest net revenue o f the two firms at that locat ion. 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 JIX =J[R-(R -C- t(l - JC)) - tx\\dx 0 for F i r m 1 and i 7t2 =j[R-(R-tx) -(c + Kl-x))}ix x for F i r m 2 . Case 3 . ( U P , D P ) : In this case, F i r m 1, the h igh revenue producer, is the price leader and chooses set a uniform m i l l gate price o f p , . F i r m 2 then matches the price wherever it can and the market boundary is then determined by the indifferent supplier, or: px-tx = R -c-t(l - xj Profits for F i r m 1 are g iven by 108 (R-Pi)x w h i c h , g iven the first order conditions, y i e l d the opt imal price for F i r m 1 and market boundary D c + t p , = R X At + 4 The equi l ib r ium price schedule for F i r m 2 then becomes p*2(x) = m i n {/A -tx,R-c-t(l-x)} and profits are then JZ2 = J*. [R - (p{ - tx) -c-t(l- x)\\ix Case 4 . ( D P , U P ) : In this case the lower revenue or more inefficient F i r m 2 i s the price leader and prices uni formly , w i t h f i rm 1 then matching the price wherever possible. T h e market boundary then becomes - R + t-p^ x = It and fo l l owing the same arguments as above, the optimal price and market area for F i r m 2 become 109 P 2 -/?-(c + t) . 1 c + t X = — + 2 4r and profits for F i r m 1 are then JTj = J [R-tx-(p*2 -?( l -x)) j±c Table 10 then shows the equ i l ib r ium payoffs for each f i r m . Several points then emerge. First , discr iminatory pr ic ing emerges as a dominant strategy for both f i rms and, as such, is the unique subgame-perfect equ i l ib r ium. However , the payoff for both is greater i f each use uni form pr ic ing rather than both practicing discriminatory p r i c i n g . 9 6 T h i s is the classic prisoner 's d i l emma, and suggests that discriminatory pr ic ing emerges as the non-cooperative equi l ibr ium i n a one-shot game (that is, without repeated interaction). W h i l e each f i rm perceives it w o u l d be i n their mutual self-interest i f both chose uni form pr ic ing , 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 uni form prices w i l l be worse off. Therefore, to forestall such an outcome, each f i rm chooses a discriminatory pr ic ing system, fu l f i l l ing their expectations about the other's behaviour. Table 10. F i r m Payoffs Under Different Pricing Strategies F i r m 2 U n i f o r m P r i c i n g Discr iminatory P r i c ing F i r m 1 U n i f o r m P r i c i n g {- +t)(3 + ct) (— + t)(3-ct) \\3 ) \\3 ) 6 ' 6 (c + tf (c-3tf St ' 16r Discr iminatory P r i c ing (c + 3t)2 {c-tf 16t ' 8t (c + tf (c-tf At ' At 9 6 The payoffs become clearer i f c=0 with no loss o f generality. Profits when both price uniformly equal t/2 versus t /4f rom both practicing price discrimination, while the greatest profits come from practicing price discrimination while the other f i rm prices uniformly. 110 Figures 17 and 18 show the equ i l ib r ium price patterns for each o f these outcomes. In Figure 17, the f irms (pulp mi l l s ) are free to choose the price schedule. Under these circumstances, each f i rm (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 ) cou ld afford to pay, and then sets its prices to its o w n suppliers (sawmil ls ) accordingly. Under this discriminatory pr ic ing arrangement, the prices paid to the supplier (sawmil l ) increase w i th distance f rom the purchaser (pulp m i l l ) since the rival purchaser (pulp m i l l ) can afford to pay more as the distance between i t and the supplier ( sawmil l ) decreases. T h e market boundary is then determined by the supplier (sawmil l ) whose delivered cost just equals the marginal revenue product o f either purchaser (pulp m i l l ) , R ( in the figure f i rms have a c o m m o n marginal revenue product and c=0). In Figure 18, f i rms (pulp mi l l s ) are now constrained to fo l low a practice o f setting prices at the pulp m i l l gate. F i r m 1 now takes into account the fact that F i r m 2 looks at the del ivered cost o f purchasing f rom F i r m l ' s suppliers, g iven that each f i rm is commit ted to us ing uni form prices. F i r m 1 finds that by reducing its price, although it loses its more distant suppliers to F i r m 2 (those f i rms i n the segment A B ) , , the increase i n profits der ived f rom lower ing the price f rom P to P ' to its closest suppliers (segment O A ) more than compensates for the lost supply. E a c h f i r m then takes this effect into account when determining its prices, leading to lower equi l ib r ium prices since each f i r m knows the other cannot raise the price to increase its supply area without rais ing the price across a l l o f its o w n suppliers. T h i s constraint is the reason that un i form pr ic ing , when practiced by both f i rms, yie lds the greatest profits o f the two different systems. Furthermore, since dpi dR=l, this means that as R, the marginal revenue product, increases, loca l i zed Bertrand competi t ion drives up the purchase price by an equal amount. T h i s is why 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 is completely offset by higher input prices. I l l Figure 17. Discriminatory Pricing by Firm 1 and Firm 2 Firm 1 Market boundary Distance Firm 2 Figure 18. Uniform Pricing by Firm 1 and Firm 2 113 Therefore, the model predicts that i n a non-cooperative game, discriminatory pr ic ing w i l l emerge for spatially separated purchasers, whi le uniform pr ic ing w i l l emerge as the equi l ib r ium outcome for f irms located coincidental ly. Prices can be expected to move proportionately wi th changes i n the end product price, but p r i c ing systems w i l l not change. Note that neither price pattern is that observed i n the B C Interior. F o r coincidental ly located pulp mi l l s , the predicted outcome is for uni form pr ic ing , w h i c h means lower prices for more distant suppliers (sawmil ls ) as the purchasers (pulp mi l l s ) incur higher transportation costs, w h i l e for separately located purchasers, suppliers w i l l f ind that their prices increase the closer they are to an alternative purchaser. A l t h o u g h discriminatory pr ic ing incorporates the possibi l i ty o f setting uni form prices across suppliers (since f irms are free to choose any price system they wish) , this type o f pr ic ing does not emerge as the solution i n the unconstrained game. Therefore, i t is necessary to mode l uni form net prices across suppliers to see the potential payoffs f rom this type of p r i c ing system. U n i f o r m Supplier P r i c i n g P r i c i n g systems i n w h i c h f irms charge identical prices to a l l customers, inc lus ive o f del ivery costs and regardless of their locat ion, are commonly cal led Uniform Delivered Pricing ( U D P ) systems (they are also sometimes cal led postage stamp systems). T h e equivalent p r i c ing system f rom a purchaser's point of v i ew w o u l d be one where they pay the same price to a l l suppliers, w i th transportation costs then added. T o dist inguish i t f rom the four schemes discussed earlier, i t w i l l be termed U n i f o r m Supplier p r ic ing ( U S ) to reflect the fact that prices are set identical ly across a l l suppliers (which i n this case are sawmil l s ) . Case 5. ( U S , U S ) : Unde r uni form supplier p r i c ing , how market areas are determined becomes important. Because suppliers (sawmil ls) receive the same price whi le the purchaser (pulp m i l l ) pays for the transportation costs, the total delivered cost varies directly wi th locat ion so that the chips f rom the most distant s awmi l l supplying the pulp 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 se l l ing to either purchaser and, mak ing the c o m m o n assumption i n these models that suppliers w i l l sel l to the nearest purchaser i n the event o f a tie, the market is then evenly split between both f i rms. Unde r such assumptions, there is a large discontinuity between the payoffs f rom continued market sharing and deviating slightly f rom the c o m m o n price, as the deviating f i r m can 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). Depending on the current price, the market area for the deviating f i r m may effectively double whi le the market area for the other f i rm w i l l collapse to zero. However , at higher prices, the deviat ing f i r m may not want to purchase f rom the most distant f i rms (those closest to the rival purchaser) as the delivered cost o f goods f rom those suppliers may exceed the marginal revenue o f the input. Therefore, the mode l appears i n a s l ight ly different fashion f rom above. T h e assumptions employed i n the previous mode l s t i l l ho ld (although the assumption c>0 is dropped for ease o f expos i t ion) . 9 7 First , the f irms calculate the payoffs i f they choose a c o m m o n price (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 rom deviating f rom that price Jti = f[R-p - tx]dx when p s R-t o or Given 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 high revenue firm, which equals 1/2 when c=0. 115 R Jtt = j[R-p -tx\\ w h e r e x = and p > R - t — 2 w h i c h equals - j - . The payoffs f rom not deviat ing when the other f i r m deviates are then: JEj = 0 when p s R-t or 1-1 - 2 — — tx jt. = f[R-p - txfix w h i c h equals Rx - px - . o ^ T h i s assumes that the f i rm , when deviat ing, continues using U S and prices an epsi lon above the other's price (and is unable to reduce the price over its closest suppliers for fear o f los ing them) when p s R - t . T h e deviating f i rm practices discriminatory pr ic ing otherwise, i n w h i c h case 3t profits become — when f i rms are sharing equal market areas. 9 8 8 F i g u r e 19 shows the payoffs based on the market price for market-sharing (having a c o m m o n price) and the payoffs for the deviating f i rms when one f i r m wins market share and the other loses market share and both are f o l l o w i n g a uni form supplier p r ic ing system. This makes the assumption that the deviating f i rm prices such that any supplier within their natural market area is indifferent to selling to the other supplier, or pi = p2 - t(l - x). This can be thought o f as a natural arbitrage condit ion. 1 1 6 Figure 19. Payoffs for Different Pricing Strategies It can be seen that at prices below R-t /2 the payoffs f rom defection dominate the other two strategies. Bertrand compet i t ion drives prices up to p=R-t/2, w h i c h is a weak N a s h equ i l ib r ium i n the sense that it is a strategy where the payoffs f rom a l l three are equal and f i rms w i l l be indifferent between cooperation and defection. However , the payoff f rom pract icing price discr iminat ion is greater than f rom using U S pr ic ing when the other firm is pract ic ing U S pr ic ing . Therefore, the on ly N a s h equ i l ib r ium when firms both practice U S pr ic ing yields payoffs o f t/8, less than the payoffs f rom retaining the freedom to price discriminate o f t/4 (where c=0), so discr iminatory pr ic ing remains the dominant strategy. E v e n when firms are constrained to fo l l ow U n i f o r m Suppl ier ( U S ) p r ic ing , the same points s t i l l ho ld as i n the unconstrained game (where firms are free to choose the p r i c ing system). T h e payoffs f rom market sharing (where both firms choose a c o m m o n price level) fo rm once again the classic prisoner's d i l emma, and increases i n the marginal product translate into a proportionate change i n prices even i f both firms adhere to U S pr ic ing . A l t h o u g h f i rms find that they can increase profits i f they choose a l o w enough price under a U S pr ic ing system, firms ind iv idua l ly face the possibi l i ty o f greater profits f rom increasing the price fractionally given the dramatic changes i n market area. In the Nash equi l ib r ium, each firm w i l l choose the price that ensures their market area, and that the price level w i l l fluctuate directly w i th changes i n the end product value. However , the N a s h 117 equi l ib r ium under jo in t U S pr ic ing has lower profits and is dominated by the equi l ib r ium where f irms are free to choose whichever prices they want. Therefore, U S pr ic ing does not emerge as the outcome o f the unconstrained non-cooperative game. Note that for f i rms located coincidental ly, Bertrand competi t ion continues to drive prices up such that uni form m i l l p r i c ing is the dominant outcome (unless f i rms are constrained to fo l low uniform sawmi l l pr ic ing) . T h e models o f non-cooperative behaviour outl ined above show that the pattern o f prices observed i n the Interior o f supplier prices invariant w i th respect to distance cannot be expected to emerge as the natural outcome o f either type o f market structure g iven no constraints on how f i rms can set prices. The models predict that when firms are located coincidental ly that uni form m i l l p r ic ing remains the unique N a s h equ i l ib r ium w i t h prices paid to supplies fal l ing w i t h distance. In those markets where purchasers are spatially separated, the mode l shows that prices pa id to sawmi l l s should increase w i t h distance. In order to understand how such systems may develop, then, it is necessary to examine what happens when f irms interact o n an ongoing basis, g iven that the models above are one-shot 99 games. Repeated Interaction W h a t happens when firms take into account the l ike l ihood that their present actions w i l l have an effect on future prices? F i rms now take into consideration not on ly how their current price or action may affect current profits, but also the effect o n future profits since their choice may cause the other f i rm to alter its behavior. It turns out that the possibi l i ty o f future profits tempers competi t ive behavior, and that more profitable strategies may emerge for both f irms than i n a one-shot game. Espinosa (1992) incorporates the effects o f this interaction through having f i rms engage i n an infinitely repeated game or super game. T w o firms face spatially distributed customers wi th unit 118 inelastic demands and simultaneously choose pr ic ing strategies and prices at the beginning o f each period. The f i rms then compare the payoffs f rom cont inuing to fo l l ow the current p r ic ing system against deviat ing f rom that pattern. I f a f i r m deviates, it enjoys the profits for one period, after w h i c h both f i rms revert to what is termed a punishment path, or a set o f prices designed by the other f i r m to reduce the profits for the deviating f i r m to the lowest possible l eve l : 1 c „ d d p l-d l-d In Espinosa ' s (1992) mode l , f i rms have the opt ion o f choos ing one o f two p r i c ing systems: U n i f o r m De l ive red Pr ice system ( U D P ) , (where customers pay the same del ivered price at their location); and F O B pr ic ing (where customers pay a c o m m o n factory gate price 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 taking into account the benefits o f continued cooperation versus the one period gain f rom defection. T h e result o f such assumptions is that the pr ic ing scheme and price level adopted by both purchasers w i l l be the same i n equ i l ib r ium wi th the choice o f prices and pr ic ing systems dependent on the exogenous parameters wi th in the model . T h e model has three such parameters: 6, the discount factor or rate; t, transportation costs; and R , the reservation value o f the customers . 1 0 1 In this m o d e l , the discount rate measures the relative payoffs f rom continued cooperation and possible defection and is bordered by [0,1], where 0 can be thought o f as ignor ing the future payoffs w h i l e 1 values future payoffs equally wi th the current per iod (no discounting). This terminology reflects the fact that firms only have one chance to determine how they w i l l set their prices. ' F O B pricing is equivalent to Uni form Pr ic ing when the firm is exercising market power on the purchasing side, while U D P is a type of discriminatory pricing (as the net realization for different customers varies) and is equivalent to Uni form Supplier pricing (US) . ' The reservation value is the maximum value a customer is w i l l i n g to pay or the min imum price a seller must receive. These values are imposed to provide a bound on prices under the assumption o f perfectly inelastic demand (supply) curves. 119 The most profitable p r i c ing scheme, regardless o f the f i rms ' locations, is to set prices as h igh as possible; i n other words, equal to the customers ' reservation values. Consequently, f i rms w i l l f o l l o w a U n i f o r m De l ive red P r i c ing system. W h e n firms are purchasing their inputs, the equivalent system w o u l d invo lve setting the purchase price as l o w as possible. I f suppliers a l l had to receive the same m i n i m u m price to supply a good, this w o u l d then y i e l d a U n i f o r m Suppl ier p r ic ing system (where the purchasers w o u l d pay the c o m m o n m i n i m u m price plus the transportation costs). A s the exogenous variables change, however, the prices and p r ic ing systems m a y no longer be the i opt imal choice. F o r example, as the discount rate decreases, ceteris paribus, firms find that the gains f rom unilaterally defecting outweigh those f rom continuing to fo l low the prevai l ing prices. T o forestall such actions, firms w i l l lower the price level to offset the gains f rom potential defection. Espinosa (1992) then showed that at certain values and combinations o f these exogenous parameters, the pr ic ing scheme w o u l d also change as co l lus ion became easier under the alternative pr ic ing system. Since the potential profits and the payoffs f rom defecting are different under the two pr ic ing schemes, given the same parameters, the firms adjusted their prices and chose the strategy that y ie lded the highest discounted stream of future payoffs to forestall the threat of defection. Ul t imate ly , conditions become such that the equi l ibr ium price level 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 competi t ive prices and price system, and this benchmark differs depending on firm locat ion. Espinosa (1992) shows that for coincidental ly located firms, the equ i l ib r ium 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 only the transportation costs to that locat ion (plus any costs incurred i n the production o f the good). F o r discount rates greater than 1/2, any price leve l or system can be sustained, and g iven that U n i f o r m De l ive red P r i c i n g is the most profitable, that w i l l be the observed price system. 120 For spatially separated sellers, prices w i l l move f rom U n i f o r m De l ive red P r i c ing through F O B pr ic ing before returning to U n i f o r m Del ive red P r i c i n g again as the discount rate increases(the equivalent for a purchaser w o u l d be m o v i n g f rom U n i f o r m Suppl ier 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 Suppl ier system). H o w e v e r , Espinosa (1992) restricts the f i rms to the choice o f on ly the two pr ic ing systems even i f they are deviating i n the m a i n part of the model , w h i c h rules out the Nash equi l ib r ium developed i n Thisse and V i v e s (1988). W h a t happens, then, i f the mode l is broadened to inc lude this possibi l i ty? The Importance of Punishment Paths in Determining Nash Equilibria One cri t ical assumption that Espinosa makes is that the punishment path chosen by the firms yields an effective payoff o f zero economic profits (i.e. the firm earns on ly the normal rate o f return). A b r e u (1988) shows that any path can be sustained i n a perfect equ i l ib r ium when firms revert to the worst possible outcome after a deviat ion. T o create a punishment path where the payoffs equal zero for eternity, the mode l requires the firms to punish one another by commit t ing to a series o f prices such that i f one firm deviates, the other w i l l price such a way i n the next period that although it loses money i n that period, the other firm makes zero economic profits. F r o m that point on , both firms w i l l make zero economic profits ad infinitum. W h i l e the l ike l ihood o f f irms commit t ing to such a range o f action seems questionable, as noted earlier many o f these models have outcomes where these punishment paths are never observed as the threat o f such act ion is sufficient to forestall any deviat ion. E v e n i f the firms do not revert to the punishment path, their promises to f o l l o w such a path have to be plausible, or sub-game perfect. That is , i f firms d id arrive at the point where they had to fo l low the punishment path, w o u l d they prefer to fo l l ow another set o f actions? F o r example, imagine a firm promises to price below cost to drive the overal l price level down i f another firm deviates f rom their market-sharing agreement. However , i f the other firm does deviate, then that firm w i l l find 121 that it incurs losses by sel l ing at such l o w prices, wh i l e the other f i r m w i l l s imply shut down and earn zero profits. T h e firm could instead punish the deviating firm by pr ic ing at cost, s t i l l lower ing the price level and having the other firm earn zero profits, but no longer incurr ing losses itself. Therefore, the threat to price below cost is not consistent and neither firm w o u l d expect the other to behave i n such a way . It turns out that i n the model developed by Espinosa (1992) that the chosen punishment path is unsustainable for firms i n separate locations when discriminatory pr ic ing i s a l lowed. F i rms can sustain posit ive profits when they revert to the Nash equi l ib r ium i n the one-shot game, and neither firm can drive the other's profits down to zero without consistently incurr ing losses itself: therefore, such punishment paths no longer become plausible. F i rms instead w o u l d revert to the non-cooperative equi l ib r ium after deviation and earn profits o f t/4, and therefore the results f rom Espinosa ' s (1992) mode l no longer h o l d and firms no longer swi tch back and forth between different p r ic ing sys tems . 1 0 2 In this case, i t is the Discr imina tory P r i c ing system and the U n i f o r m Suppl ier p r ic ing system that are o f interest, since the first reflects the outcome under deviat ion (or competi t ive behavior) whi le the latter represents the potentially most profitable system and the hypothesized pattern i n the Interior market. In the first case, the payoffs f rom discriminatory pr ic ing are: Note 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 equ i l ib r ium payoffs o f t/4. In this case, the payoffs f rom deviat ion a lways outweigh the payoffs f rom cooperat ion when the discount rate is less than 1/2, and when the discount rate is greater cooperation is the preferred strategy. T h i s happens as the gains f rom deviat ion are twice that f rom cooperation when the long term 122 effects o f reverting to the non-cooperative outcome are taken into account. Since any price can be sustained when the discount rate is greater than 1/2, the m a x i m u m profits that can be obtained under this pr ic ing arrangement are R/2-t /4 (the f i r m sets a price o f zero for the closest supplier) . Tu rn ing to uni form supplier pr ic ing , the profits again f rom cooperation versus deviat ion are: 1 c . d d P \\-d \\-d Once again, cooperation can be sustained for any discount rate i n excess o f 1/2 and any price can be chosen. In this case, the f irms choose the monopsony solut ion, m a x i m i z i n g profits by setting the purchase price to zero, and rea l iz ing profits o f R/2-t /8 . Therefore, the profits are higher than those that can be obtained under discriminatory pr ic ing. These results are different f rom those found using the Esp inosa (1992) mode l when pr ic ing systems are constrained to fo l l ow either a un i form del ivered price or a un i form purchase price. In that mode l , f i rms alternate between the two systems, adjusting prices i n response to changes i n the exogenous factors (the discount rate, transportation cost, or reservation value, equivalent to the net revenue i n this model) . In a broader sense, the Espinosa (1992) mode l is unrealistic i n its suggestion f i rms costlessly switch between pr ic ing systems and adjust prices smoothly without reverting to what are termed the punishment path strategies. Furthermore, as a theoretical question, i t is not clear w h y f i rms, i f they do decide to deviate, should be constrained to either the F O B or uni form pr ic ing systems when the above model shows that both strategies are dominated by discr iminatory p r ic ing . A s such, i t suggests that Espinosa ' s (1992) mode l needs to be modi f i ed by incorporating the possibi l i ty o f a reversion to a discr iminatory pr ic ing system. It may be the This shows how dependent the equil ibrium may be on the choice of punishment. 123 case that the principal result, namely that uniform delivered pr ic ing systems may reflect the possibi l i ty o f either very competi t ive or co l lus ive behavior, is incor rec t . 1 0 3 A l l o w i n g for repeated interaction shows that supra-competitive profits may be sustained i f firms can choose and fo l low a particular p r ic ing system that yields greater profits than the non-cooperative outcome. In other words, the jo in t ly beneficial outcome i n a prisoner 's d i l emma that is not sustainable under one-shot N a s h games become supportable w i th repeated interaction. There is a range o f potential equi l ibr ia , a l l equally supportable depending so l ong as the discount rate firms use exceeds a cr i t ical value. T h e most profitable equ i l ib r ium is that where firms can 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 price, the result w o u l d be a U S pr ic ing system. However , the mode l suggests that firm behaviour and prices can change sharply i f the discount rate fal ls be low the cr i t ical value, and firms then move f rom a tacitly col lus ive outcome to the non-cooperative outcome. F i rms then revert to the mode l described by the one-shot game. Shapiro (1989) notes that wh i l e the discount rate i n games o f repeated interaction is c o m m o n l y used to represent the value firms place on future actions, i t can also be thought o f as characterizing how qu ick ly firms may respond to one another's actions or the firms' beliefs about how l i k e l y the game is to con t inue . 1 0 4 It can be shown that the discount rate decreases as the reaction per iod lengthens or the firm thinks that the game w i l l end sooner than i t previously bel ieved. F i n a l l y , this mode l brings to the forefront an important issue that is typ ica l ly glossed over i n most game theory models. Since any equi l ib r ium can be sustained when the discount rate is greater than 1 0 3 Espinosa (1992) argues that there is no sustainable equil ibrium in F O B prices below a certain discount rate and therefore the equi l ibr ium must take the form of a uniform delivered pricing system. However, under such a system, firms are forgoing potential profits by not charging more to their nearest customers which they could do by altering their prices and hence the solution is not a Nash equil ibr ium. 1 0 4 \" F o r m a l l y , 6 may be thought of as the product of two terms: b=ve'iT, where v is the hazard rate for the competition continuing (i.e. the probability that the game continues after a given period, given that is has not previously ended), and e\"'T is the pure interest component of the discount factor, wi th period length T and interest rate i . \" (Shapiro 1989:365). 124 1/2, how do firms arrive at a particular Nash equi l ibr ium? In particular, g iven the inherently unstable market areas under a uniform supplier p r i c ing system, how do firms arrive at a c o m m o n price? Kreps (1990: 529-531), i n his textbook o n mic roeconomics and game theory, discusses this very question: What's wrong with the game theoretic approach? The discussion above centers o n the (in)ability to moni tor [referring to a lengthy discussion o f models i n v o l v i n g noisy market prices and whether or not changing prices reflect deliberate deviations or demand shocks]. B u t there is another problem, intui t ively s imilar , to contend wi th i n applications. W h a t do y o u monitor? W h e n we have symmetric firms, i t seems \"obvious\" that w e should look for symmetric equi l ibr ia wherein every f i r m acts i n the same way. B u t i n an o l igopoly of asymmetric firms, i t w o n ' t be crystal clear just what is the \"rule\" each is supposed to f o l l o w . . . W e have returned to two closely related weaknesses o f this approach: T h e t w i n problems o f too many equi l ibr ia and the selection o f one o f them. Compare the model o f this section wi th the Cournot , or Ber t rand, or v o n Stackelberg mode l . In the three classic models, a definite prediction i s made about what w i l l happen. One can (and we do) argue that this definiteness arises speciously. Insofar as the repeated play model is the right mode l , the classic models make an ad hoc assumption about r iva l s ' conjectures, w h i c h is v i r tual ly equivalent to assuming w h i c h equ i l ib r ium pertains. Unless there is some reason g iven for the ad hoc assumption, nothing has been gained except perhaps to expla in what sort o f conjectures lead to certain equ i l ib r ium outcomes.... A second lacuna i n the theory is apparent when we examine closely the c l a i m that specifying institutions helps us to understand outcomes, at least i n noisy environments. T h i s may be true as far as it goes.. .But it leaves open the question, Where d i d the institution come from? M o r e generally as w e look across industries, do variations i n the \"rules\" reflect uncontrollable environmental differences, or are institutions the result o f some conscious or unconscious choices by participants? W e w i l l not resolve these puzzles at this point. In fact, w e won ' t resolve them i n this book at a l l ; their fu l l resolutions are over the hor izon o f economic theory at this point .\" In this case, the influence o f government po l icy may w e l l provide the miss ing pieces identified by Kreps (1990) on how a particular equ i l ib r ium may be sustained. T h i s mode l shows that when firms^an coordinate their actions under certain condit ions, i t may be possible to sustain supra-competitive outcomes. However , a characteristic o f such 125 equi l ibr ium is that i f they are disturbed, the reversion to more competit ive behavior can happen qu ick ly and prices can change significantly. F i g u r e 2 0 shows several different pr ice series for residual w o o d chips i n the B C Interior. T h e first, Actual, is the average price paid to sawmil l s i n the Interior over the study period (the data used to derive these series is discussed more fu l ly i n the next chapter). The next two series illustrate the non-competit ive and competi t ive outcomes suggested by the mode l . T h e next series, Percentage, is constructed by taking 9% o f the se l l ing pr ice o f pulp, reflecting the use o f government-mandated m i n i m u m pr ic ing restrictions during the in i t ia l development o f the market through the 1970s, and is meant to reflect non-competit ive price-setting. T h e f ina l series, Margin, is constructed by deducting cash manufacturing costs (chemicals , labor, overhead, and energy) f rom the se l l ing price o f pulp, adjusted for y i e l d for a kraft pulp m i l l , and is meant to reflect competit ive pr ice-set t ing. 1 0 5 I f we assume that pulp m i l l s face constant marginal costs, Margin then provides a measure o f the marginal 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 competi t ive markets (Armst rong 1975). T h i s has also been the approach used i n other studies to estimate the (imputed) value o f pu lpwood (Naut iya 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 closely track the f ixed percentage o f the pulp price over m u c h o f the t ime period, and then more closely match the series derived f rom net revenues. T h i s is consistent w i t h the idea o f f i rms f o l l o w i n g a specific p r i c ing system and then reverting to the sub-optimal outcome as the fundamental dynamics o f the prisoner 's d i l emma reassert themselves. ' Costs were conservatively set at $400 per metric tonne to include overhead and delivery costs but to exclude fibre costs, based on reported costs for the Interior pulp industry derived from Table A l 13, B C M O F (1995). N o allowance was made for inflation. 1 2 6 Figure 20. Actual and Constructed Price Series for Wood Chips in the BC Interior W h i l e the model shows that a move towards more competit ive behaviour w i l l be marked by higher prices, the increase i n prices observed i n F i g u r e 2 0 may reflect other forces at work i n the market. In order to test the mode l , it is necessary to examine whether or not the increase i n price levels can be attributed to the change i n f i rm behaviour noted i n the Interior. In addit ion, the model also shows that the pr ic ing pattern o f un i form sawmi l l prices observed i n the past cannot be explained by competi t ive behaviour. Furthermore, the model shows that more competi t ive behaviour w i l l lead to a change i n spatial pr ic ing patterns. F i n a l l y , the mode l suggests that as competi t ive behaviour increases, interaction between f irms may also increase since they w i l l now 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 pr ic ing practices are consistent w i th the model outl ined above. 1 2 7 4. Tests of Price Discrimination in the Wood Chip Market in the British Columbia Interior T h i s chapter empir ica l ly tests for the presence o f market power using two approaches. T h e first relies on a comparison of the Interior residual w o o d chip 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 level match those predicted by the mode l as firms move towards more competi t ive behavior. Tests of Market Price Levels T h e intui t ion behind the first approach is the ' L a w of One P r i c e ' , w h i c h says that for units o f an \"identical good...[one price] is indeed a log ica l consequence o f economic rationality and competitive markets.\"(Caves, Frankel , and Jones 1990). T h i s l o g i c underlies spatial equi l ib r ium models, where regional markets clear as arbitrage dictates that goods move between markets to the point where equi l ib r ium prices i n each market w i l l differ only by the transportation costs between each market. I f the difference i n equi l ib r ium price between a market is less than the transportation cost to any other market, that means that demand and supply w i l l equilibrate w i th in that one market. In the absence o f market power or any k i n d o f export restrictions one w o u l d a priori expect a l l sawmil ls to receive the same price for their w o o d chips, less the difference i n transportation costs between their locat ion and the market wi th the highest equ i l ib r ium price. The m a i n difficulty o f these approaches is separating the effect o f market power f rom other factors that may affect loca l markets, such as changes i n regional demand, supply, or technology that w i l l affect prices. F o r example, changes i n the demand for pulp can affect 128 the price o f w o o d chips, wh i l e the adoption o f different technologies, such as C T M P , could also be expected to affect the demand and hence price for wood c h i p s . 1 0 6 It is also possible to use this reasoning to examine the pattern o f prices pa id i n loca l markets. W h e n f i rms are located coincidental ly, the uniform supplier p r ic ing system means that a purchaser w i l l util ize more distant chips that are more costly than nearby local chips i f loca l markets are unable to satisfy their demand. U s i n g data on prices and volumes, i t is possible to calculate the difference between what a purchaser actually pa id for their chips and what they w o u l d have pa id had they been able to acquire the same amount o f fibre at a l ower cost. Unde r a U n i f o r m Suppl ier p r ic ing system, a pulp m i l l cou ld save money by no longer purchasing chips f rom its more distant suppliers and replacing them wi th chips f rom a closer s awmi l l (since the ch ip price w o u l d be the same but the pulp m i l l w o u l d save on transportation costs). However , that s awmi l l is supply ing the r iva l purchaser and the f i r m has to we igh the benefit f rom reducing its fibre cost against the possibi l i ty that such action may lead to higher prices (and both purchasers w i l l end up paying more i n the long run). T h e potential gains are calculated by summing up the cost o f acquir ing an equivalent amount o f fibre f rom the closest sawmil l s and then deducting the cost o f supply f rom exist ing suppliers using imputed transportation cos t s . 1 0 7 T a b l e 11 shows the actual differences for two pulp m i l l s i n the Pr ince George Forest R e g i o n for selected months (the months were chosen for a representative range o f suppliers and to coincide w i t h the period under w h i c h i t is assumed f i rms were f o l l o w i n g a U S p r i c ing system). T h e differences are considerable, and are the more str iking for their persistence. Such differences w o u l d not be expected to last under the assumption o f competi t ive behaviour. ' It should be noted that the prices observed in F igures 13 a n d 14 are inconsistent with such models. However, as noted in Chapter 3, spatial price discrimination is not inconsistent with models of competitive behavior, especially at the f i rm 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. Supply was aggregated based on distance, moving from the closest to next closest supplier to satisfy the reported purchases for that period. These estimates are conservative, as not al l suppliers would be listed for each month. 1 2 9 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 price indices for w o o d chips over a ten year per iod i n three distinct markets: the B C export market (North Vancouver) ; the Northern Interior market (otherwise k n o w n as the Pr ince George market); and the Puget Sound market for Douglas-f i r chips i n the Pac i f i c Northwest . T h e w o o d chips sold i n these three markets are very s imilar ; i n fact, some o f the chips sold i n Nor th Vancouve r originate f rom the Northern In te r io r . 1 0 8 S imi l a r species i n terms o f quality are used (it should be noted that Douglas-f i r is regarded as sl ightly less desirable than the export m i x o f chips sold i n N o r t h Vancouver , w h i c h is at least 5 0 % spruce and the rest pine and true firs). Therefore, wh i l e actual prices i n these regions w o u l d differ due to region specific transportation costs and other costs o f pulp production, such as labor and energy, relative price levels should be s imilar , according to the ' L a w of One P r i ce ' . However , there is one substantial difference between these three markets. There are no restrictions on the export of w o o d chips f rom the U S ; consequently, any supplier is free to sell their chips into the wel l -developed export market that exists on the W e s t C o a s t . 1 0 9 W i t h i n B C , restrictions o n chip export restrict the possibi l i ty o f such arbitrage, but the participation of l imi ted volumes i n the export market does offer a measure o f the value of those chips. Expor t volumes ranged between 6% and 15% of total Interior product ion over the period 1987 through 1995 for w h i c h data was available (see Table 3 and Table 4). ! The prices i n al l three markets were comparable in 1986. ' The Puget Sound market is felt to be very competitive, as suppliers are free to sell into the export market i f they are unhappy with the price offered by local purchasers. (Ekstrom, 1996). 130 A we l l -known example o f market comparisons has been work examining the impact o f l og export restrictions on l og prices o n the B C Coast. M a r g o l i c k and U h l e r (1992) showed that export restrictions have depressed domestic prices i n the Vancouver l o g market, compared to l og prices i n the U S l o g market i n Puget Sound. F i g u r e 2 1 shows the trend for prices i n Puget Sound, the export market, and the B C Interior, based on Canadian dollars. Pr ices i n Puget Sound c lose ly f o l l o w export prices, reflecting the interaction between those two markets, whi le B C Interior prices fo l lowed both markets unti l 1990 when price levels started increasing i n those markets but remained flat and even trended d o w n w a r d s . 1 1 0 Interior prices continued to diverge f rom prices i n the Puget Sound and export market unt i l 1994, at w h i c h point interior price levels rose rapidly, and prices i n a l l the markets were again m o v i n g i n tandem. T h i s evidence suggests that there are factors at work i n the Interior market not present i n the other two markets. ' The increase i n the late 1980's has been generally attributed to concerns about reduced harvest levels in the Pacific Northwest due to the spotted o w l . 1 3 1 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 Northwest , quarterly reports Figure 22 looks at the relative production o f chips i n the Interior to examine the possibi l i ty that there may have been some region-specific supply shock, or that the pattern of prices may mechanical ly reflect change i n pulp prices due to formula pr ic ing . It can be seen that chip production has remained relatively constant over the eight-year period. Figure 22 also shows quarterly indices for Interior w o o d ch ip prices a long wi th pulp prices for 1987 through 1996, again based on Canadian dollars. T h e sharp increase i n chip prices starting i n the second quarter o f 1994 is immediately apparent (prices nearly doubled), wh i l e pulp prices d id not exceed the h igh f rom the previous cyc le unti l the beginning o f 1995, nearly one year later. 132 Figure 22. Relative Change in Prices and Production 1987-1996 o 3 0 0 1 : i 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 — r — i — n — I I I I—I I I 1987:3 1989:1 1990:3 1992:1 1993:3 1995:1 - Inter ior Price —B— - Export Price - Pulp Price - Interior Production (Source: W o o d F i b r e Northwest , C O F I ) A r e there other factors specific to the Interior that might expla in the different price patterns? A s noted i n Table 6, w i th the exception o f the expansion i n pulp capacity at Ce lgar , annual pulp capacity i n the Interior has changed little since 1989-90, the last h igh point i n the pulp price cyc le . There have not been any recent entrants into the Interior industry. T h e only pulp m i l l buil t since 1987, the Lou i s i ana Pac i f ic pulp m i l l i n C h e t w y n d , relies solely o n aspen roundwood chips. There were no significant changes i n ownership w i th in the industry over the same period. P o l i c y changes regarding stumpage and environmental regulation postdate the change i n prices (the impact these change might have on future supplies is discussed more fu l ly i n Chapter 5) . Therefore, at the t ime w o o d ch ip prices shot up, industry structure had remained remarkably stable and the industry had not yet faced any significant po l i cy changes. Furthermore, pulp prices and chip production levels i n the Interior chip market were not 133 substantially different than they had been i n previous periods. T h i s suggests that changes i n industry structure or regional demand and supply are un l ike ly to explain the change i n Interior prices. Testing for Changes in Market Price Levels T h e existence of an export market provides the means to test whether the hypothesized change i n market behaviour explains the increase by using the export market as a measure o f the true marginal value o f w o o d chips. T h i s approach fo l lows M a d h a v a n et a l . (1994), w h i c h examined the market for dairy products i n the U S and found significant differences between the marg in for two types o f m i l k (equivalent i n quality) sold by dairy cooperatives before and after an antitrust decree. B y assuming that prices i n both the export and Interior market w i l l respond equally to any overa l l changes i n w o r l d demand for pulp , expressed as changes i n the price o f pulp , it is possible to dist inguish to what extent factors specific to the Interior market are inf luencing prices i n the Interior market. In the case o f the Interior market, we are interested i n testing two variables that may expla in differences i n price levels whi le ho ld ing the effect o f pulp 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 product ion o f pulp fibre wi th in the Northern Interior less consumption wi th in the r e g i o n . 1 1 1 T h e region is a net exporter o f pulp fibre so that production historical ly exceeds consumption wi th in the region. T h e difference between the two is a measure o f the relative avai labi l i ty o f residual chips; increases i n demand or decreases i n supply 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 lead to price increases i n the Interior under competi t ive conditions. 1 1 1 This data was derived from the C O F I C h i p Aud i t Task force, described in both the data appendix and in Chapter 6. The data set covers production and consumption of all pulp fibre, including roundwood chips, on a quarterly basis within the northern Interior (the Prince George, Prince Rupert, and Cariboo Forest Regions). This is the same region where chip prices first started to increase. 1 3 4 T h e second variable o f interest is Change. It is constructed as a d u m m y variable designed to measure the presumed change i n market behaviour between the two periods, and equals 1 after the first quarter o f 1994 (as February 1994 was the month the chips were put up for bid) . A n y change i n the behaviour o f relative prices i n these two markets after this date not p icked up by the other variables w i l l show up as a significant coefficient on this variable. The third variable is Pulp, w h i c h equals the value o f bleached kraft pulp exported f rom B C for that quarter, and accounts for changes i n the price firms pay i n the Interior due to formula pr ic ing . The fourth and f inal variable is Time, to a l low for the possibi l i ty that there was a dynamic component affecting prices not p icked up i n the other var iab les . 1 1 2 The dependent variable is Margin, and equals the Expor t pr ice less the Interior price, d iv ided by the export price. It therefore shows the difference between the two price levels expressed as a percentage o f the export price, and ranges between 0 (when the two prices are equal) to 1 (when the domestic price equals zero). T h e higher the margin , then, the greater the discrepancy between prices i n the two markets. Equa t ion (1) shows the mode l that was estimated. T h e data used i n the estimation are discussed i n the section Allowing firm interaction. (1) Margint = j8 0 + j8, x Excesst +fi2x Time + j83 x Pulpt + /3 4 x Change + st Results from Testing for Changes in Price Levels Table 12 reports the results o f a regression corrected for auto-correlation. W h i l e the coefficients for Time, Pulp , and Change were a l l significant, the measure o f loca l demand relative to supply, Excess, was insignificant although i n the correct direct ion (since decreased availabil i ty i n the local market should raise the price i n the local market relative to 135 the export market and therefore decrease the margin). T h i s suggests that changes i n loca l demand relative to supply do not explain differences i n price levels; rather, the explanation lies i n a change i n market behaviour. Table 12. Margin as a Function of Demand and Market Power, n=30 Variable Constant Excess T i m e P u l p Change Coefficient t-ratio .767 (4.52) - 3 . 4 9 * 1 0 3 (.26) 4 . 4 9 * 1 0 ^ (2.16) -5.17*10\"* 1 (7.16) -3 .34* 10J (1.98) Critical value of t for 95% level of confidence=1.96 Durbin H Statistic=.58; RJ=.91 T h e s ign o f the Change variable is consistent w i th the hypothesis; a move towards more competitive behaviour w o u l d be expected to lead to higher prices i n the domestic market relative to the export market, leading to a decrease i n the margin. In addit ion, the posit ive and significant s ign o n the variable Time shows that the marg in was g rowing over t ime (this can be seen i n Figure 21). T h e negative s ign for Pulp suggests that the marg in decreased as the price o f pulp rose (although this effect was an order o f magnitude less). T h i s suggests that the difference i n price levels between the two markets shrinks i n relative terms as the overal l price leve l rises. Table 12 shows that there was a significant shift i n relative price levels i n the Interior and export markets between the first period cover ing prices through 1987 and the first quarter o f 1994, and the second per iod cover ing the second quarter o f 1994 through 1996. These two periods were chosen to reflect hypothesized differences i n f i rm behaviour based on differences i n how contracts were put up for b i d and signed w i t h i n the Interior market. Prices i n the Interior market during the second per iod m o v e d closer towards the export 1 1 2 Excess is based on the consumption and production of pulp fibre within the Central and Northern Interior (also known as Region One). 136 price, consistent w i th the idea o f increased competi t ion i n the Interior market. C a n more competitive behavior also be seen at the firm level? Tests of Firm Prices and Pricing Patterns The model developed i n Chapter 3 showed how a specific pr ic ing pattern, namely a U n i f o r m Suppl ier p r i c ing system, where the price pa id to suppliers was the same regardless o f their location, cou ld lead to greater profits than more competit ive behaviour. T h e model also showed that more competi t ive behavior was associated wi th increasing prices and a change i n the spatial pattern o f prices. T h e first part o f this section tests two hypotheses: first, prices have been set i n the Interior as a percentage o f the pulp price and have been constant across sawmil l s ; and second, there was a significant change i n prices and pr ic ing patterns. D u e to data l imitat ions, however, the per iod tested only covers the first few months of the hypothesized change i n market behav iou r . 1 1 3 T h e second set o f tests are derived f rom the other predictions made by the mode l and rely on changes i n firms' prices relative to other prices and exogenous changes i n the value o f w o o d ch ips . Testing for Formula Pricing If purchasers are indeed setting prices according to a c o m m o n U n i f o r m Supplier p r i c ing system, then the price pa id by ind iv idua l purchasers to their suppliers should reflect this practice. Specif ica l ly , (2) P ^ V + 1 1 3 Information identifying individual suppliers and purchasers was not available due to a change in data collection methods. 137 The price pa id to sawmi l l s , P , is derived f rom the presumed formula w h i c h is assumed to equal a fixed percentage o f the pulp m i l l ' s net se l l ing price, R . 1 1 4 Transportation costs, t, are replaced by 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 pulp m i l l s i n the Interior have practiced third degree price discr iminat ion and set prices o n a uniform sawmi l l basis then the coefficient on distance should be zero. P , t is the price o f lumber, and is inc luded to test whether lumber may influence ch ip prices (see Chapter 3 for a discussion o f how lumber prices may provide a floor). In addit ion, a t ime trend is incorporated. T h e mode l contains two distinct breaks, separating the study per iod into three intervals. T h e first interval covers the period f rom December 1987 through the end o f 1989, when the provinc ia l government was t rying to raise chip prices i n the Interior market through mora l suasion (see the section entitled \" C h i p Di rec t ion P o l i c y Dropped\" i n Chapter 2). W i t h i n this period, i t is assumed pulp m i l l s are f o l l o w i n g fo rmula pr ic ing but may have responded differently ( i f at al l) to government pressure to raise prices. T h e second interval covers the per iod f rom A p r i l 1989 through February 1994, dur ing w h i c h per iod pulp m i l l s were presumably pract icing formula pr ic ing without any government pressure. The third interval comes after the change i n purchaser and supplier behavior i n February , 1994, when chips were put up for b id , and the purchasers were deviat ing f rom the o ld formula p r i c ing system. Data T h e data set for this estimation consists o f 2,562 individual arms-length transactions for w o o d chips i n the Interior o f Br i t i sh C o l u m b i a for the per iod December 1987 to Ju ly 1994. Purchasers include ten o f the pu lpmi l l s wi th in the region and the largest purchasers o f 1 1 4 Recall that the reservation value in the models discussed in Chapter 3 provided an upper or lower bound. The results for the Uni form Supplier model showed that a non-competitive equil ibrium could be sustained i f firms were able to agree on a common price that fell wi thin the range of reservation values ( in the case of residual chips, this would be a minimum that sawmills would need to receive to stay open and the maximum the pulp m i l l would 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. 1 3 8 residual chips f rom 52 sawmil l s wi th in the region. B o t h prices and quantities are reported for each transaction but not a l l transactions are necessarily reported for each month. However , each pulp m i l l and s awmi l l is represented i n the data set. Several months o f data i n 1988 and 1989 are miss ing , so the total number o f months covered is 6 8 . 1 1 5 T h e dependent variable is the observed price o f residual chips i n Canadian $ 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 is measured between the s awmi l l and the purchaser i n kilometers, wh i l e Pulp is the average monthly gross price reported for bleached Kraf t pulp exported f rom Br i t i sh C o l u m b i a by Statistics Canada i n $ per metric tonne. Before is a d u m m y variable for the per iod January 1987 to M a r c h 1989, s ignif ied as Per iod I, and is chosen to co inc ide w i t h government intervention to raise chip prices i n the Interior i n the spring o f 1 9 8 9 . 1 1 6 After is a d u m m y variable for the per iod February 1994 to Ju ly 1994, s ignif ied by Per iod III, and is chosen to coincide wi th the hypothesized change i n f i r m behavior (again distinguished by a change i n how chips were bought f o l l o w i n g the chips put up for b i d i n Quesnel) . B o t h Before and After are interactive dummies wi th the lagged pulp price, whi le only After is interactive w i t h distance. Lumber is the price per thousand board feet o f S P F 2 x 4 lumber, random length, Standard and Better, f rom the Interior f rom Madison ' s Canad ian L u m b e r Reporter, whi le Time is a monthly time trend that increases by one wi th each month over the sample period. A l l prices are i n nominal Canadian dollars, reflecting the fact that these were the prices f irms were using i n their dec i s i on -mak ing . 1 1 7 Equat ion (3) shows the exact mode l where A . . . J represent ten purchasers i n the interior (all pulp mi l l s ) , w i t h i the chip purchases f rom that ind iv idua l s awmi l l . 1 1 5 Appendix 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 in Chapter 3. 1 1 7 The lumber price was reported in U . S . dollars and converted into Canadian dollars. K = Po + PulPt-i x{Pi + P2 x Before + j83 x After) + Distance u x (fiA + 6S x A/ter) + j86 x Lumbert + /J 7 x Twze Model E s t i m a t i o n a n d D i s c u s s i o n of the R e s u l t s T h e m a i n purpose o f this mode l is to determine whether a uni form pr ic ing system was practiced wi th in the Interior and the relationship between product prices and chip prices. T a b l e 13 reports the results o f estimating equation (3) for each o f the ten purchasers separately wi th t-ratios reported be low the estimated coefficients, as w e l l as summary statistics. Coefficients significant at the 9 5 % leve l are i n bo ld . T h e equations have been corrected for autocorrelation where present. T o preserve the confidentiality o f the ind iv idua l purchasers, only the difference i n the percentage o f the pulp price between period II (the longest interval i n the data set, cover ing A p r i l 1989 to February 1994) and the two f lanking periods are reported (these periods are marked I and III) respectively. T h e purchasers include: C a r i b o o P u l p and Paper, Canfor , Ce lgar , Cres tbrook, Eurocan , F in l ay , Fletcher Chal lenge, N o r t h w o o d , Quesnel R i v e r Pu lp , and Weyerhaeuser. A s an additional precaution, ind iv idua l sample sizes are not reported: the smallest sample contained 4 5 data points, whi le the largest sample contained 624. T h e first set o f coefficients, Pr ice o f Pu lp , can be interpreted as expressing the chip price as a percentage o f the pulp price. F o r example, purchaser A increased the price pa id by .60% o f the price o f pulp between Per iod I and Per iod II, and then by 3 . 44% between Per iod II and Per iod III. F o r a l l purchasers, the price o f pu lp was h igh ly significant, and ranged between 7 .2% to 9 .91% for the ind iv idua l purchasers, w i t h an average o f 8.8% for nine o f the ten purchasers i n per iod I I . 1 1 8 5 Purchaser F was excluded due to an estimate four times greater than that of the other firms. The higher estimate offsets the significantly larger negative constant term for this f i rm. The sample size for this f i rm was quite small (N<50) reflecting the fact that they are not a major purchaser o f chips in the Interior market, and these results may reflect a different pricing practice. 1 4 0 Table 13. Estimating Wood Chip Prices as a Function of Product Prices and Distance Paid by Pulp Mills in the BC Interior F i r m Pr ice o f Pu lp (% of pulp price) Distance cents/km L u m b e r cents/Mbf T i m e cents/ month Constant R 2 | I II III I I I III A - .6 (1.12) * (9.30) 3.44 (4.28) - .9 (1.00) 3.1 (1.72) - .9 (1.44) .27 (2.30) -3 .22 (.29) .56 | B - .5 (1.14) * (11.51) 4.47 (6.90) -.1 (-22) 2 .0 (1.56) - .5 (.55) .17 (1.82) -1 .72 (.20) .39 j ; c - .5 (.71) * (8.08) 4.0 (4.84) -3.5 (3.73) -2 .4 (1.07) -2.1 (.15) .31 (2.00) -7 .08 (.54) .38 j • D -.1 (.15) * (11.15) 4.9 (5.61) -2.4 (3.86) .8 (.30) -1.3 (1.28) .26 (2.36) -7 .95 (.81) .48 j i E -1 .0 (1.46) * (7.56) 8.4 (11.75) .3 (.43) -8.6 (5.24) -1 .4 (.13) -.11 (.82) 18.16 (1.62) .73 | | F na * (5.23) 5.1 (2.51) .2 (.15) -5 .2 (1.51) -5 .6 (1.85) 1.92 (3.57) 183.65 (3.53) .63 j 1 G -1 .9 (1.71) * (3.85) na -22 .2 (2.10) na 2 .2 (.87) .05 (.24) 27 .60 (1.19) .48 ! 1 H - .2 (.18) * (5.07) 6.3 (6.46) .9 (.59) -7.5 (2.56) 1.8 (1.02) .06 (.29) .58 (.03) .68 - .9 (1-92) * (10.23) -2.1 (1.32) -2.2 (4.00) 4.7 (2.55) 3.8 (3.23) - .04 (.36) -5 .76 (.58) .61 • | J * \" .2 (.33) * (11.32) 4.2 (3.76) .3 (1.07) - .9 (.75) -1 .0 (.91) .15 (1-49) -10 .04 (1.05) .73 : * suppressed 1 na=not available I **current i ***iagged two periods i Critical value for t for 95% level of confidence = 2.306 Eigh t o f the purchasers showed an increase i n the price pa id between Per iod I and Pe r iod II; however, the difference was on ly significant for purchaser I. E igh t o f the purchasers showed significant increases i n the price pa id between Per iod II and Pe r iod III, wh i l e purchaser I showed a slight but insignif icant decrease. Because the pulp price used is based on the price at the point o f export, and it cou ld not be specified how long the t ime lag w o u l d be between what firms w o u l d receive versus when pulp w o u l d be shipped, various t ime lags were used to calculate w h i c h per iod w o u l d provide a better fit. In terms o f t iming , the pulp price lagged one period provided the best 141 fit. T h e two exceptions were purchaser I, where the current per iod provided the best fit, and purchaser J , where the price two months ago provided the best fit. T h i s may be due to differences for those purchasers between processing and shipping or may reflect different p r ic ing practices. T h e second set o f coefficients i n T a b l e 13 show how the prices pa id to sawmi l l s differed by their locat ion; for example, sawmil l s w h i c h sold to purchaser A found that the price they received was lower by .9 cents per B D U for every ki lometer o f distance between them and purchaser A during Periods I-II, wh i l e i n the Per iod III the price rose by 2.2 cents per B D U per k m (3.1 cents -.9 cents). Three firms, C , D , and I pa id prices dur ing the first two periods that significantly fe l l wi th distance; however, the change i n price was much less than the actual cost o f transportation (prices dropped between 2 and 4 cents per B D U per kilometre but the actual cost o f transportation is closer to 15 cents per B D U per kilometre). Th i s may reflect a historic pr ic ing 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 disa l lowed and some more distant sawmil ls apparendy received less for their chips as a result (Cooper 1995). Purchaser G d i d show prices that fe l l and that were comparable to the magnitude o f actual costs; however, these results were significant at the 9 0 % leve l . F o r the remaining six firms, prices d i d not vary significantly wi th distance. Three o f the firms, E , H , and I, saw a significant change i n the influence o f distance on price i n per iod III, where the price now fel l for E and H w h i l e the price rose for F i r m I. T h e next set o f coefficients i n T a b l e 13 shows how the price pa id for chips was influenced by the price o f lumber. F o r example, a $1 increase i n the price o f a thousand board feet dropped the price pa id by purchaser A .9 cents per B D U . O n l y one purchaser, I, showed a significant effect: a $1 increase per thousand board feet o f lumber l ed purchaser I to raise its price by 3.8 cents per B D U . F o r the most part, other purchasers reported negative but insignificant effects. 1 4 2 F i n a l l y , the T i m e variable shows the t ime trend for chip prices, ho ld ing a l l the other variables constant. F o r example, i n the case o f purchaser A , the pr ice was increasing b y 27 cents per B D U per month over the t ime period. T w o o f the ten purchasers, D and F , showed significant increases whi le the rest showed no significant change. Quite clearly uniform sawmi l l p r ic ing , or formula pr ic ing based on a percentage price o f pulp explains 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. Prices ranged around the percentage used as the m i n i m u m price by 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 price sl ightly f rom the first period to the second i n response to government intervention, a l l but one significantly increased the price they pa id w e l l above previous levels during the third period (which is chosen to cover the period during w h i c h it is hypothesized pulp m i l l s reverted to more competi t ive price-setting behavior). T h e evidence is somewhat more m i x e d i n terms o f the spatial pattern o f prices. T h e mode l predicts that the prices received by sawmil ls f rom pulp 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 wi th distance i f the two purchasers are located separately). W h i l e several purchasers d id show significant changes i n the price pa id as a funct ion o f distance, on ly two purchasers, E and H , showed prices actually vary ing i n magnitude comparable to actual transportation costs. In terms o f market structure (i.e. prices rising under separate locations and fa l l ing under coincident locations), the changes were i n the predicted direct ion for s ix o f the nine f i rms ( A , B , C , H , I, and J) (no data was available i n this per iod for f i r m G ) . These m i x e d results may reflect the fact that the data available for this estimation covers the first several months on ly of the hypothesized change i n f i r m behaviour, and that not a l l the price changes are fu l ly captured. ' The original percentage was based short tons, while pulp today is sold in metric tonnes. T o convert from a short ton to a metric tonne, divide by 1.1. A n indirect confirmation o f the spatial change i n pr ic ing practices comes f rom information released by the M i n i s t r y o f Forests, w h i c h reports the average price o f chips for different points wi th in the Province that coincide wi th the locat ion o f sawmil ls . W h i l e the reported prices include both an imputat ion for transport costs and the effects o f averaging across a l l m i l l s w i th in a region, these prices do provide some addit ional information on spatial patterns when 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) Per iod Pr ince M c B r i d e Vanderhoof Burns L a k e H o u s t o n Smithers George West Line East Line East Line East Line East Line 1994 $60 $55 $55 $55 $54 $57 (Per iod II) Difference from - $5 $5 $5 $6 $3 Prince George price 1996 $200 $180 $192 $188 $186 $178 (Per iod III) Difference from - $20 $8 $12 $14 $22 Prince George price (Source: Interior Average Chip Values Effective July 1, 1994 and July 1, 1996, from BCMOF Interior Valuation manual) Table 14 shows reported average chip values for two different regions i n the Interior: the Wes t L i n e , the rai l l ine extending west f rom Prince George to Pr ince Rupert wi th several . sawmil ls located along the way; and the East l ine, the same ra i l l ine running east through Valemount . T h e model predicts that competi t ive pr ic ing should lead to the two purchasers paying a uniform del ivered price i n Pr ince George, w i th the price pa id to sawmil l s fa l l ing the further away they l ie f rom Pr ince G e o r g e . 1 2 0 A l t h o u g h these reported values include adjustments for del ivery points and freight costs, the under lying formulae were not changed dur ing the two periods, and are based on prices f rom the preceding year w i th a three-month lag . Therefore, the increase i n the difference between the value o f residual chips i n Pr ince George and o f other chips i n the surrounding These prices include prices paid by firms other than the three mil ls in Prince George. 144 area between July o f 1994 (based o n average prices f rom A p r i l , 1993 through A p r i l , 1994) and Ju ly 1996 (based on A p r i l , 1995 through A p r i l , 1996) is due to changes i n the prices paid for chips between each o f the different locations. Quite clearly, price levels fa l l m u c h faster as y o u move away f rom Pr ince George i n 1996, compared to 1994, w i th the difference comparable to actual transportation costs . 1 2 1 Market Power and Firm Reactions T h e results presented i n T a b l e s 13 a n d 14 are strongly suggestive o f a change i n ch ip price determination i n the Interior beginning i n 1994. However , they are restricted by data l imitat ions and by the fo rm of estimation, w h i c h examined how changes i n end-product prices affected the prices pa id by f i rms for w o o d chips. Quite clearly, another factor i n terms o f the how f i rms set prices is how they w i l l respond to changes i n each others' prices. T h e mode l shows a potentially abrupt discontinuity as f irms move f rom a relatively stable pr ic ing system to a more competit ive pr ic ing scheme, as f irms instantaneously swi tch pr ic ing systems and change price levels . The real w o r l d is more complicated. F i rms (pulp mi l l s ) may not immediately recognize deviations f rom exist ing pr ic ing systems; alternatively, they may resist raising prices at first unt i l the possible risk o f los ing a chip supplier becomes clearly established. Furthermore, the model suggests that firms can costlessly and smoothly switch to the opt imal p r ic ing system under compet i t ion. However , transaction costs may be significant, and firms may not recognize the opt imal system, especially under rapidly changing conditions and imperfect information. F i rms may decide to simultaneously increase a l l their prices without changing the pr ic ing system; this may be even more l i ke ly i f the firms have had a long history o f f o l l o w i n g certain p r i c ing systems. 1 4 5 A more plausible formulat ion is that f i rms, instead o f instantaneously m o v i n g f rom one equi l ib r ium to another, effectively enter a transition state where the prices they set w o u l d depend i n part upon what they think others are paying . In some sense, f i rms w o u l d develop reaction functions, w h i c h w o u l d dictate how they w o u l d respond to another f i rm ' s pr ices . There are many models wi th in game theory that examine how assumptions about reaction functions can change outcomes. It should be stressed that i n these models , reaction functions have a functional stable form; that is , wh i l e prices may be changing, the f i rms ' behaviour remains invariant. Estimating Response Functions Mode l s that empir ical ly examine f i rm interaction are rare, reflecting the difficulty i n obtaining sufficient f i rm level data. One model that does is Slade (1986), who specif ical ly examined f i r m interaction i n her study of gasoline pr ic ing during a gasoline war i n V a n c o u v e r i n the summer of 1985. In the mode l , a f i rm's demand curve i s based o n the prices set by i tself and other f irms and on other exogenous factors. It is then possible to derive the parameters o f the demand curve and identify the predicted reaction function o f the f irms. T h e mode l can then be used to estimate the f i rms ' reaction functions—how f i rms alter their prices i n response to changes i n other f irms' prices—and tested against the behavior predicted under certain conjectural assumptions. Slade (1986) collected prices f rom both major and independent gasoline stations i n Vancouver during a price war to see how closely the actual outcome matched theoretical predictions o f cooperative and non-cooperative behavior. T h e actual estimation wi th in the model gauged how each type o f It is approximately 200 k m from M c B r i d e to Prince George and 98 kilometres from Vanderhoof, suggesting imputed transportation costs on the order of 10 cents per B D U per k m in 1996. 146 f i rms ' prices change i n response to changes i n the other's prices, and showed that increased responses were correlated wi th greater compe t i t i on . 1 2 2 Examining Firm Interaction T h e mode l developed i n Chapter 3 does not have expl ic i t reaction functions. Buyers practice Bertrand pr ic ing , w h i c h means they anticipate that the r iva l buyer w i l l pay slightly more i f the f i r m attempts to purchase the good for less than the m a x i m u m the other f i r m is w i l l i n g to pay ( in some sense this is a k i n d o f instantaneous ratcheting up o f the price). Under the assumption that f i rms are using a U n i f o r m Supplier p r i c ing system and that f irms use a f ixed percentage o f the price o f pulp to coordinate prices, we should then , observe a swi tch to prices based on marginal revenue when f i rms start to behave compet i t ively. F i rms do respond to one another's prices only i n the sense that they w i l l match each other's prices i n the competi t ive equi l ib r ium. Specif ica l ly , f i rms w i l l respond to the other's ind iv idua l marginal revenue i n gauging what price to set, and they may use the price paid by the other f i r m as an indicat ion o f their marginal revenue (as i t w o u l d be i n a competitive market). There are two hypotheses that can be tested. The first is an expl ic i t prediction o f the model : i f f i rms do swi tch f rom f o l l o w i n g some k i n d o f p r ic ing system to a set o f more competi t ive prices, there should be a measurable change between the two periods; that is , a significant difference i n how prices evolved wi th in each o f the two periods. T h e second hypothesis is more indirect and looks for how ind iv idua l f i r m responses to one another may have changed between the two time periods. A priori, one w o u l d expect that under a perfect pr ic ing system al l f i rms w o u l d use a f ixed percentage of the pulp price and ignore changes i n one anothers' prices, wh i l e under the assumption o f a complete reversion 1 2 2 Slade (1986) notes that her model was l imited to examining the behavior o f gasoline stations only during the price war, as the uniformity o f prices during periods of price 'peace' meant that there were no significant differences to be examined. 147 to the Prisoners ' d i l emma firms w o u l d immediate ly start paying the fu l l residual marginal value. The truth is l i k e l y to l i e somewhere i n between the two (for example, suppose one f i r m fo l lows a p r i c ing system, and other f irms base their prices o n the price leader); however, one w o u l d expect increased f i r m interaction as f irms move towards a more competitive ou tcome. 1 2 3 G i v e n that the data set covers a per iod o f rapidly rising prices, and the assumption that prices w i l l be m o v i n g towards more competi t ive levels , one w o u l d expect to see a posi t ive increase i n f i rms ' responses. T h e estimation procedure used is based on the Vec to r Autoregressive ( V A R ) model used i n estimating dynamic simultaneous equations. Judge et a l . (1988) provide an overv iew of this approach, w h i c h is used for mult iple t ime series where there is interaction between the variables. T h e approach involves running simultaneous equations o f different autoregressive processes that may include exogenous explanatory variables. T h e advantage of this approach is that i t a l lows for error terms to be correlated across the equations w h i c h a l lows for greater efficiency i n estimation. Data T h e data set used to estimate ind iv idua l p r ic ing patterns ended i n Ju ly 1994 as access to the database was te rminated . 1 2 4 Further research identified a set o f monthly prices for the f ive largest purchasers w i th in the Interior f rom January 1995 through February 1996, y i e ld ing an addit ional 100 data points. A s these prices were those reported by the purchasers for a l l their transactions, the ind iv idua l transactions f rom the previous data set were aggregated to produce weighted average purchaser prices to make the two sets comparable. T h e total number o f months covered between December 1987 and February 1 9 % was 80 . Howeve r , due to miss ing transactions (either no information was available for a specific month or 1 This approach is similar to one fol lowed by Slade (1986), which uses Granger causality to test for price exogeneity as a means of determining market boundaries. 1 This appeared to reflect a growing uneasiness about looming trade actions vis-a-vis the Americans coupled with a change in how the data was collected. 148 there was no information on one o f the f ive purchasers for that month), the f inal per iod covered was f rom the beginning o f 1990 through February , 1996. One problem wi th estimating time-series equations is that the process may be non-stationary due to the presence o f t ime trends, seasonal patterns, or t ime-varying variances. T h e problem appeared i n the latter part o f the period and it was necessary to take first differences to ensure the process was stationary. Modeling Firm Interaction The mode l permits two specific formulations to be tested, using either a f ixed percentage o f the pulp price during the per iod o f price coordination, or the residual value o f the chips during the period o f competi t ive behavior, as was done i n Figure 2 0 . T h e model forces no restrictions on what period f i rms observe the price o f pulp or the marg in available other than that they do not forecast future prices. However , the differences i n f i rms observed other f i rms ' chip prices are restricted to periods prior to the current per iod i n w h i c h the f i r m is setting its o w n chip price. G i v e n the secrecy wi th w h i c h ch ip prices tend to be guarded, i t is not possible to specify how qu ick ly pulp f i rms may learn about one anothers' prices. Therefore, a one and two period lag were examined to see w h i c h provided the best fit . Pu lp prices were transformed by taking 9% o f the current price so that the magnitude o f the response was comparable to other f i rms ' prices; this d i d not change the overal l f i t and meant that the coefficient could be interpreted i n terms o f how w e l l the price changes matched changes i n the percentage sel l ing price o f pulp. A l l o w i n g for f i r m interaction and the possibi l i ty that f i rms d id respond to one another's prices changes leads to equation (4), w h i c h shows the price pa id by a f i r m as a function o f changes i n the price o f pulp and changes i n other f i rms ' prices: 149 (4) A P . - f t x A f t i f c ^ + J ^ A I * j,t-b where a>0 and b> 1. A l l o w i n g for prices to respond to changes i n the marginal value product leads to equation (5). In this case, marginal value product is constructed as i n F i g u r e 2 0 by subtracting $400 f rom the price o f pulp , correcting for the y i e l d (about 45%) , and deflating to convert current costs into nomina l prices for previous pe r iods . 1 2 5 T h e specific equation is : Results from Estimating Firm Interaction T a b l e s 15 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 on the f i r m ' price, w i th the subsequent f ive columns the effect o f that particular f i rms ' price. T-ratios are reported under each variable and coefficients significant at the 9 5 % level are i n bold . The R 2 fo l lows each equation, and the A k a i k e Information Cr i te r ion ( A I C ) is also reported for each set o f equat ions . 1 2 6 In addit ion, both sample periods were evaluated using the alternative measures Pulp or Margin to see w h i c h provided the better fit w i th in each period. It turned out that the previous per iod pulp ' s pr ice , as suggested i n T a b l e 13, provided the best fit dur ing the period o f assumed price coordination, wh i l e the current margin provided the best fit dur ing 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 This was the cost per tonne of producing pulp in B C , excluding fibre costs, in 1994 ( B C M O F 1995). Because the recovery rate is 4 5 % (that is, one tonne of wood chips w i l l y ie ld .45 tonne of pulp), the marginal value of wood chips is arrived at by deducting the manufacturing cost of chips from the selling price and then mul t ip lying 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 of the variable in question. W i t h a process of order 1, the test for Granger Causality is the equivalent of a T-test. 1 2 7 Best fit was that set of equations that minimized the A I C within that order. In addition, the R 2 for the individual equations was greater for three o f the five equations, compared to those using pulp. (5) APa = A x margin ,_ a + ] > \\ w / 3 A / > j.t-b where a>0 and b> 1. 1 5 0 Table 15. Price Behavior under Assumed Price Coordination, 1990-February, 1994 (n=51) F i r m P u l p A B C D E R1 A .14 .47 - .06 .02 - .06 .03 (.27) (.95) (.38) (.11) (.34) B .61 -.11 .03 - .07 .19 .30 (4.38) (2.47) (.54) (1.21) (2.84) C .38 - .16 -.31 .59 .13 .26 (1.09) (1.47) (.88) (4.01) (.76) D .68 - .05 - .25 - .15 .02 .11 (2.10) (.44) (.85) (1.40) (.15) E .63 .27 .21 -.01 -.21 .16 (2.09) (3.63) (.70) (.11) (1.64) C R I T I C A L V A L U E O F T F O R 9 5 % > L E V E L O F C O N F I D E N C E ( O N E -SIDED)=1.94 A I C = •16.418 In the first period, pulp prices are significant for f i rms B , D , and E , and comparable i n magnitude, w h i l e pulp prices are posit ive but insignificant for the other two firms. In terms o f the t iming o f the response, prices pa id by other f i rms for residual chips us ing a two per iod l ag provided a s l ighdy better fit than one or three per iod l ag . There was l imi ted f i r m interaction, w i th B showing a negative response to f i r m A ' s price and a posit ive response to E ' s , wh i l e f i r m E showed a posit ive response to f i r m A ' s price. F i r m C also showed a posit ive response to changes i n f i r m D ' s pr ice. F i r m A lies between B and E , w h i l e F i r m D is the closest f i r m to C , suggesting a geographical reason for some o f the interaction. T h e second per iod, when open b idd ing for chips occurred, provides more ambiguous results. W h i l e f i r m A shows that the available marg in played a significant role i n determining its prices, three o f the four f i rms show the marg in had a posi t ive but insignificant effects whi le the fourth, C , shows a negative but insignif icant effect. F i r m s B , C , and D show strong and significant responses to changes i n F i r m A ' s price and negative responses to F i r m E . In addit ion, F i r m B , shows a negative response to C s price. 151 Table 16. Behavior of Prices After Open Bidding Commenced: March, 1994 - February, 1996 (n=16*) F i r m M a r g i n A B C D E R1 A .43 - .20 .44 - .22 .13 .48 (3.10) (.94) (1.28) (.60) (.65) B .09 2.81 -.64 .58 -1.83 .60 (.59) (2.91) (2.12) (1.56) (2.08) C - .06 3.34 .15 .15 -2.62 .73 (.59) (7.49) (1.56) (.93) (6.35) D .12 1.78 -.01 .03 -1.18 .55 (1.06) (2.79) (.06) (.15) (1.97) E .18 .32 -.01 .33 - .39 .21 (1.05) (1.22) (.05) (.74). (.85) \"reflects miss ing 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 Prices paid by other f i rms i n the past per iod now provided a sl ight ly better fi t , suggesting the t iming o f their responses had shortened. Interaction between f irms increased, both i n the number o f inter-firm responses f rom three i n the first per iod to seven i n this period, as w e l l i n the magnitude o f the overa l l responses for most f i rms. S u m m i n g across the response by each f i r m to each other f i rm ' s price to create an overal l reaction, three o f the f ive , B , C , and D showed an increase i n their reaction, m o v i n g from the per iod o f assumed price coordination to the reversionary per iod. F o r example , F i r m s B ' s react ion increased f rom .04 to .92, F i r m C s f rom .25 to 1.02, and F i r m D f r o m -.43 to .62. F i r m E remained relat ively unchanged, w i t h .26 i n the first per iod and .25 i n the second, wh i l e F i r m A ' s overa l l reaction dropped f rom .37 i n the first per iod to .15 i n the second. T h i s pattern o f reactions can be explained i n part by the locat ion o f the various firms. F i r m E is located the furthest f rom the other four firms, wh i l e firms B , C , and D are the closest to each other. F i r m A is located relat ively equidistant to the other four. The ind iv idua l responses suggest that F i r m A was act ing as a price leader, at least for firms B , C , and D . F i r m E appears to have lagged other firms in i t ia l ly i n raising its prices but then fo l lowed F i r m A very c losely, and this may expla in the apparent negative response by the other firms to its price changes. 152 T a b l e 16 suggests prices d id not immedia te ly and simultaneously move towards a system o f price based on the marginal value o f w o o d chips. W h i l e the mode l shows that f i rms w i l l respond immediately by increasing the price to the m a x i m u m point they are w i l l i n g to pay when coordination fails, the results suggest actual f i r m behavior was more complex and that one f i r m became a price leader, w i th the responses differing among the ind iv idua l firms. In part, data l imitations restricted the number o f firms that cou ld be included i n the sample (although the five firms included are the largest purchasers wi th in the Interior) and the t ime per iod that cou ld be used i n the estimation. G i v e n the l ong history o f f o l l o w i n g a specific p r i c ing system (e.g. formula pr ic ing based on a percentage o f the output price), it is not surprising that i t may take t ime for firms to adjust their expectations about how other firms w i l l a c t . 1 2 8 It should be noted that the mode l developed does a l low for price leadership w h i c h i n turn, depending o n the firm configuration, may lead to a Bas ing Point system. R e c a l l that the mode l showed that firms do not want to practice price leadership, but w o u l d rather instead fo l low a price leader. It may be the case that price leadership i n this case may reflect a transitory stage between the U S pr ic ing system and discriminatory pr ic ing . T h e results do show that there was a change i n the p r i c ing process consistent w i t h those expected under increased competi t ive behavior. W h y d i d firm behaviour change? R e c a l l that the discount rate can reflect firms expectations as to how long a particular game to last (or i n another sense how long firms w i l l behave according to the same rules). T h e fact that a s a w m i l l (and perhaps most importantly the largest s awmi l l company i n the Interior) was w i l l i n g to put its chips up for b id , coupled w i t h a wi l l ingness by at least some purchasers to respond, appears to have led to pulp m i l l s rapidly revis ing their beliefs i n the stability o f both formula pr ic ing and the fixed nature o f their historic market areas. T h e dynamics o f the prisoners ' d i l emma asserted themselves wi th a vengeance, as purchasers realized that cont inuing to fo l l ow the o ld system meant that they w o u l d 1 2 8 In an interview with George Edgson, then vice-president with Slocan, the company that first offered its chips up for b id i n the Interior, he noted that the init ial bids by companies varied quite widely and that one company submitted a b id that basically reflected past practices. Even after g iv ing the company another chance to resubmit its bid , they left the bid unaltered. The only explanation Edgson could offer was that they felt that no other company wou ld try to purchase chips from that sawmill . 1 5 3 l i ke ly lose a significant port ion o f their supply. T h e end result was a m o v e away f rom chip prices based on a l o w percentage o f the pulp price towards prices based o n the marginal value o f w o o d chips, a long wi th increased f i r m interaction as pulp m i l l s actually competed for suppliers. Summary In summary, the significant increase i n price levels o f pulp chips starting i n 1994 is associated wi th a change i n market power due to a change i n f i r m behavior. W h i l e i t appears somewhat puzz l ing how such a change can have such an abrupt impact i n terms o f such rapid increase i n price levels , as seen i n Figures 21 and 22, such an increase i s consistent when the participants find themselves i n a prisoners' d i l emma. T h e participants move from a beneficially jo in t outcome to a less desirable outcome (and remain there) so long as each firm anticipates the other firms w i l l no longer adhere to a particular set o f rules. In this case, the f i rms ' abi l i ty to coordinate prices among themselves d iminished sharply as they m o v e d away f rom formula pr ic ing , and the result was a significant increase i n the overal l price leve l . Tradi t ional explanations o f market power i n this context w o u l d have missed m u c h o f the explanation for the change i n prices. Neither market structure nor market concentration, the classical determinants o f market power, changed over the study period. U t i l i za t ion rates, whi le peaking i n the summer o f 1995, post-dated the change i n behaviour o f some ch ip sellers, and w o u l d be mis leading i f used as the sole criterion. W h i l e the relative demand and supply o f chips influenced the degree o f the price move to some extent, it was ultimately a change i n firm behaviour most responsible for the dramatic change i n prices. His tor ic supply relationships that had existed unchanged since the introduction o f ch ip direction twenty years earlier dissolved as sawmil l s put their chips up for auction and pulp m i l l s b i d against each other. 1 Pulp m i l l s w i th in the area, by virtue o f their size and locat ion, do enjoy inherent structural market power, m u c h as an isolated s awmi l l w i l l enjoy market power i n its l oca l l og markets. However , government po l i cy during the in i t ia l development o f this market helped to reinforce the pulp m i l l s ' market power. F o r example, ch ip direct ion provided a way for f i rms to organize their suppliers without hav ing to compete for t h e m . 1 2 9 Chapter 1 showed that many of the pulp companies felt that the m a i n problem associated wi th the proposed P A ' s i n the 1980's and 1990's was the introduct ion o f uncertainty as a result o f the loss o f directed chips and a potential re-ordering o f supply relationships. Restr ict ions on the export o f chips also reduced potential competi t ion f rom purchasers outside the region, along w i t h the uncertainty associated w i t h the potential for market entrants. 1 3 0 I n addition, the cooperative nature o f F ib reco Expor t , through its average cost p r ic ing , also lessened the potential for competi t ive pressures f rom the export market. F i n a l l y , even when the chip direct ion po l i cy 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 th in their area. T h i s appeared to work m u c h l ike clauses among retailers guaranteeing that they w i l l match or beat the lowest advertised price; under such condit ions, f i rms are u n w i l l i n g to lower prices to attract additional customers because any price cuts w i l l be matched, reducing the l ike l ihood o f any increase i n market share. C h i p direct ion helped define where pulp m i l l s received their supply; once that concern was sorted out, purchasers cou ld focus on the issue o f what prices to pay. The introduction o f m i n i m u m pr ic ing provided an expl ic i t s ignaling d e v i c e . 1 3 1 B u r n s (1936, p. 84) provides an analogy i n the introduction o f m i n i m u m pr ic ing for steel i n the U S i n the 1930s and how it l ed to price uniformity among the major steel producers. 1 2 9 \"Alber ta also introduced 'chip direct ion ' i n the 1970's which still exists today. Sundance (a sawmill in Edson) has asked the provincial government to axe chip direction, which severely depresses chip prices.\" K o c h , 1995 1 3 0 Other potential purchasers include pulp and paper mi l l s on the B C Coast. The key for them is transport costs for Interior chips and the cost o f alternative supplies. 1 3 1 In the technical language of game theory, this provides a focal point which enables participants to choose among a variety of potential equilibria. 155 M i n i m u m chip pr ic ing d id m u c h the same i n the Interior by provid ing a structure (a percentage o f the pulp price) that reduced the computational uncertainty i n t rying to figure out what other buyers were paying . A s Scherer (1980) pointed out, identifying 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 could 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 consumpt ion and product ion o f pu lp fibre i n the northern Interior on a quarterly basis and circulates wi th in the pulp and paper industry. It provides a means for firms to monitor one another's actions. B y ident i fying suppliers and inventory levels , i t further reduces the uncertainty surrounding the supply o f chips i n a large part o f the Interior and helps facilitate price coordination (recall the quote f rom Phl ips (1981) i n Chapter 2). The presence o f such a report, a long w i t h the reliance on the percentage set by the government in i t ia l ly , suggest that these information requirements are quite important i n leading to these types o f tacitly col lus ive outcomes. M o r e generally, see H o w a r d and Stanbury (1990). A l o n g the same lines, i t is interesting to note that under conditions o f ol igopsony, firms appear to prefer setting prices at the supplier 's locat ion as opposed to the purchaser. F o r example, the Federal Trade C o m m i s s i o n i n 1934 issued an order requir ing that large m i l l s purchasing cottonseed to stop publ ishing b i d prices w h i c h were calculated at the shipping points, as i t was felt that such a practice l ed to non-competi t ive p r i ce s . 1 3 3 A report issued by a Congressional committee i n 1939 also noted that i n the scrap metal industry, where 1 3 2 This point is made by Phlips regarding the introduction o f the multiple basing point pr ic ing system in Europe for steel, where he states that \"The basic ingredient of tacit col lus ion is perfect information on actual prices, here delivered prices. Tacit col lusion 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 of the geographical structure of delivered prices.\" Note that is for firms selling as opposed to purchasing goods, but the basic principle of removing potential uncertainty remains the same. Phlips, (1983: 306-307). 1 3 3 Temporary National Economic Committee (1939: 293). 156 there were very few buyers relative to a large number o f smal l sellers, prices were quoted F O B shipping 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 pu lpwood purchasing practices i n Eastern Canada i n 1958 after allegations o f co l lus ion i n terms o f b idding . A m o n g the various memos and discussions between the various pulp companies provided to the C o m m i s s i o n regarding their purchasing practices, is one where a participant notes that purchases: \"should be F O B [rail lcar and that F O B m i l l p r ic ing was a dangerous p rac t i ce . \" 1 3 5 Prices here were for the most part determined at the supplier 's shipping point. Lofgren ' s (1985) observation that the practice of setting uni form roadside prices i n Sweden for pu lpwood reflects concave supply curves may be incomplete; this method o f quoting prices also has the strategic effect o f enabling firms to more easily coordinate prices and thereby l i m i t competitive behaviour. T h i s also suggests that Duer r ' s (1994) observation about the introduct ion o f l oca l p r i c ing i n the U . S . South for pu lpwood may be backwards; that is , loca l pr ic ing was introduced to hinder the emergence o f more competi t ive behaviour and d id not reflect increased competi t ion. T h e widespread coincidence o f roadside or s awmi l l p r ic ing w i th in pu lpwood markets around the w o r l d l i ke ly reflects participants ' awareness that this method o f quoting prices, may avert or at least du l l competi t ive behavior. A s shown by the mode l , the dramatic increase i n prices suggests that once tested, this particular price equi l ib r ium was not very stable as pulp m i l l s engaged i n competi t ive behavior as chips were put up for b id . In the mode l , the discount rate is exogenous, and even a slight change i n the discount rate can be sufficient to lead firms to move f rom one outcome to another. W h i l e i t is not possible to weight how m u c h firms' evaluation o f future benefits and costs changed, i t seems un l ike ly that either reaction periods (that is , the amount of t ime it w o u l d take f irms 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' changing bel ief about how l i k e l y the previous system of fixed 1 3 4 Ibid. (p. 341). 157 market areas and formula p r i c ing w o u l d last. Individual f i rms ' perceptions o f how circumstances had changed appeared to vary quite substantially at first. George E d g s o n , o f Slocan, said that companies submitted wide ly vary ing bids wi th one company resubmitting the same price schedule that i t was currently using (Edgson , 1995). H o w e v e r , once suppliers started to switch, purchasers appeared to feel that they cou ld lose any port ion o f their chip supplies i f they d id not match the price changes, and as one fibre supply manager noted: \"every t ime some chips jumped f rom pulp m i l l A to pulp m i l l B , the price went up by another $ 10 per B D U \" . 1 3 6 W h i l e some firms in i t ia l ly signed contracts l i n k i n g chip prices to the price o f pulp at higher percentages than previous contracts, prices soon started to exceed these ' f o rmu la ' prices. These 'bonuses ' qu i ck ly vanished when pulp prices started to d e c l i n e . 1 3 7 T h e circulat ion o f information on chip production and consumption wi th in part o f the region suggests that pulp m i l l s are w e l l aware o f the potential competi t ion for suppliers and bel ieve they must monitor one another's actions. T h i s suggests that the information requirements to sustain these types o f non-competit ive outcomes are quite important and it is not clear to what extent information on both prices and quantities are needed. It does suggest that how prices evolve over future periods w i l l be strongly inf luenced by how purchasers perceive the security o f their loca l market areas and how they respond to one another's actions. T o the extent that pulp markets soften and demand lessens, firms m a y feel that the potential competi t ion has lessened, decreasing the perceived elasticity, and the price w i l l drop. I f new purchasers enter an area, disrupting supply patterns, prices may rise. It is un l ike ly prices w i l l continue to remain a constant fixed percentage o f the pulp price i f firms continue to worry about securing their fibre supplies. ' Restrictive Trade Practices Commiss ion (1958): 62. ' The manager wished to remain unidentified but represented a large consumer of pulp fibre in the Interior. ' This fact emerged i n a series of interviews with sawmillers throughout the region. 158 Formula pr ic ing is s imply another type o f delivered p r ic ing system where i n this case prices are set uni formly across a l l suppliers regardless o f locat ion. T h i s type o f p r i c ing offers several advantages to purchasers that practice it. First , by using a percentage o f the pulp price to set the same price to a l l its suppliers and paying for a l l the transportation costs, the pulp m i l l ensures that it captures any locational rents and a l lows it to selectively purchase f rom its suppliers i f it chooses to do so. F o r example, i f the pulp m i l l wanted to increase its purchases o f w o o d chips, i t cou ld purchase chips f rom more distant sawmi l l s that it currently didn ' t buy f rom without hav ing to raise the price across a l l o f its suppliers (where the net price received the s awmi l l is the same but the chips are more costly due to the increased transportation cos t s ) . 1 3 8 Second, this method o f price-setting enables f i rms to coordinate prices and monitor one another much more easily by significantly reducing the computational uncertainty i n determining prices. Under formula pr ic ing , a purchaser can assume that i f they learn the price paid by a r iva l purchaser to any one supplier that the price w i l l be representative o f a l l the other r iva l ' s suppliers. Purchasers don ' t have to worry about changes i n transportation costs, w h i c h are a significant part o f the del ivered cost o f fibre, and w o u l d l i ke ly affect the overal l price leve l under another type o f p r ic ing 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 ic ing also has the benefit o f reducing any incentive for sawmil l s (or a third party) to try and arbitrage to take advantage o f the difference i n delivered costs. A s each sawmi l l receives the same price for its chips, and since pulp m i l l s take care o f a l l transportation, no s a w m i l l or other party perceives any benefit f rom trying to buy and resell chips since a l l chips are price the same. F i n a l l y , this type o f p r ic ing has a superficial appeal i n that equal prices seem \"fai r\" to at least some o f the s awmi l l supplying c h i p s . 1 3 9 ! This is only true to the extent there may be sawmills wi th 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 of the stick [through a low price], then at least everybody else is as well [referring to other sawmills supplying the pulp m i l l ] . \" 159 In terms o f economic theory, these results suggest that expl ic i t del ivered pr ic ing systems do facilitate less competit ive outcomes through mak ing price coordination easier. Furthermore, as suggested by the magnitude o f the price change, such systems can lead to outcomes that take on the characteristics o f a prisoners ' d i l emma. T h e p r ic ing system m a y not be expl ic i t ly (overtly) organized to facilitate col lus ion (or as i n the case o f the Interior market reflect the unanticipated effect o f po l i cy choices). B y reducing uncertainty and prov id ing a mechanism by w h i c h f irms can establish c o m m o n prices, however , f i rms m a y now be able to reach tacitly col lus ive outcomes. Contrary to the results i n Esp inosa (1992), the more general economic mode l developed i n this thesis, supported by an examination o f actual market behaviour, suggests that un i form prices do not necessarily reflect the competi t ive outcome. Instead, these types o f p r ic ing patterns should be v i ewed wi th skepticism and examined to see to what extent they may 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 rom other pulp fibre markets i n Nor th A m e r i c a by the degree to w h i c h residual chips make up most o f the furnish. T h e inelastic nature o f chip supply, coupled w i t h the jo in t nature o f ch ip and lumber manufacturing, means it is difficult to identify the costs o f ch ip production. Together, these factors have had the effect o f mak ing pulp fibre production i n the Interior relatively insensitive to prices. In addit ion, the market for pulp chips is h igh ly concentrated on the demand side and m u c h less so the seller side. Throughout m u c h o f the Interior, there has his tor ical ly been only one or two ch ip purchasers for most sawmi l l s . Furthermore, the fact that the provinc ia l government owns most o f the forest land wi th in the province gives i t a great deal o f control over the industry. F o r example, cutting rights cannot be transferred between companies nor can exist ing facili t ies be shut down without government approval . Because the government regulates so many aspects o f the industry, even relatively \"minor\" po l i cy changes can have widespread effects. In the w o o d chip market, provincia l government po l i cy designed to protect both parties ended up creating a particularly stable pr ic ing structure that persisted past the off icial discontinuation o f any expl ic i t pol icies regarding chip pr ic ing or production. G i v e n the structural characteristics o f the market, such as an inelastic chip supply function and a very l imi ted number o f buyers, this l ed to an unusually r ig id market where neither prices nor quantities fluctuated a great deal unti l the past two years. In fact, the analysis i n Chapter 4 shows that much o f the recent change i n prices reflected changes i n f i rms ' behaviour and expectations rather than changes i n demand 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 province that w i l l also affect the market. In some cases, they may affect the supply and or demand for chips direct ly, whi le i n other cases, they indirectly affect the market through their effect on lumber manufacturing. T h e fo l lowing sections outline these trends and their potential effect on the Interior market. T h e pr imary issue, at least for the Interior, is not necessarily the phys ica l avai labi l i ty o f supply but rather the costs o f that supply. Global Trends in Demand for Pulp Fibre A common denominator throughout Nor th A m e r i c a has been the increasing use of s awmi l l residuals by pulp and paper companies as the economics o f using these residuals (as a lower cost source o f fibre relative to pulpwood) have proven increasingly attractive to pulp m i l l s . 1 4 0 A s a result, most sawmil l s now find their sales o f residual chips an integral part o f their cash f l ow , and w o u l d be unable to operate i f they cou ld not sell their chips. However , the use o f residuals has peaked, and analysts expect roundwood ch ipp ing to become increasingly important i n B C whi l e sawlog costs w i l l continue to increase as firms move into more marginal t imber stands (Anonymous 1995). A t the same t ime, both pulp and lumber markets have become noticeably more volat i le i n recent years . 1 4 1 W h i l e no definit ive analysis has been offered as to the source o f the vola t i l i ty , some possible explanatory variables include the growing integration o f the w o r l d economy, w h i c h turns loca l markets into global markets, and fibre shortages i n traditional t imber-processing areas such as the Pac i f ic Northwest during peak market cond i t ions . 1 4 2 ' T h i s trend has been most marked in Quebec, which has seen lumber shipments soar as pulp mil ls have both bought and built sawmills to take advantage of the economics of extracting as much lumber as possible out of what was previously considered pulpwood. Pulp and Paper Wood Report, October 1995, M i l l e r Freeman. 1 4 1 See, for example, Cockram (1995) and Songehen and Haynes (1994). 1 4 2 It may be the case that ini t ia l ly the entrance of other firms from outside the local market may have dramatic effects on prices depending on the market structure as local firms may f ind regular 162 These local ized fibre shortages induce price rises (where loca l ized m a y mean as large an area as the Wes t Coast o f Nor th A m e r i c a ) , w h i c h i n turn makes other markets more attractive as increased prices cover the transportation costs o f purchasing f rom more distant markets. A s exchange rates and local economic conditions fluctuate, so too does the relative attractiveness o f these markets, and changes i n demand f rom outside the traditional market area can lead to sharp swings i n p r i c e s . 1 4 3 Hag le r (19%) has suggested that smal l changes i n demand for w o o d pulp can lead to large changes i n price due to the emergence of a two-tiered global supply curve, reflecting the h igh cost producers i n Nor th A m e r i c a and Scandinavia and the emergence o f l o w cost producers i n A s i a and elsewhere. In some cases, uncertainty about future fibre supply have on ly added to the vola t i l i ty o f markets. Another explanation that has been offered as an explanation for increased volat i l i ty i n the industry has been changes i n the structure o f the industry. Increasing substitution between hardwood and softwood pulps and the g rowing number o f f i rms that can divert pulp f rom their o w n paper m i l l s into the market pulp trade have added to short term uncertainty, although these factors may moderate price changes i n the future. A n increasingly complex distribution network also makes i t more difficult to evaluate the demand and supply condit ions for pulp . In some instances, inventories may be held i n f ive different places, and the lead-time for f irms to ship pulp f rom B C to Europe can be f rom 3 0 to 4 5 days (Geist , 1 9 % ) . A s a consequence, when f irms perceive a potential market shortage, they simultaneously increase their inventories and prices qu i ck ly rise, creating a self-sustaining prophecy. T h i s mechanism also works i n reverse. A s perceptions change, f i rms l iquidate inventories and prices f a l l . There is some suggestion that even moderate adjustments o f demand/supply patterns disrupted. Over the longer term, as markets become more globalized, the increasing number of firms and consumers participating may act as a check against sudden changes in prices due to local market conditions (e.g. increased imports o f orange juice from Braz i l when frosts reduce harvests in Florida). ' In a paper presented at a conference i n Atlanta i n M a y of 1996, the consulting f i rm Jaakko Poyry suggest that big swings in the price of export logs from New Zealand in recent years can be attributed to the participation o f the Japanese buying logs in the export market. (Jaakko Poyry, 1996) 163 inventories can lead to major swings i n pulp shipments as this aggregate behaviour accentuates rather minor changes i n demand (Geis t , 1996). Ano the r long-term global trend is that o f increased cost o f fibre supplies, not on ly i n Canada, but w o r l d - w i d e . M c L a r e n (1996) reflects the th inking o f a number o f analysts who believe there w i l l be a physical scarcity o f fibre as demand for w o o d and paper products outstrips the supply o f w o o d f ibre. Hag le r (1996) argues that there is a regulatory scarcity o f fibre as pol icy-makers 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 nvo lved , is to reduce the vo lume o f fibre available and to make the remaining volume higher cost. Songehen and Haynes (1994) noted that real prices for stumpage i n the Pac i f i c Northwest have shown a steady increase since the early 1900s; they also noted that the margins between lumber and stumpage i n the region have steadily shrunk over t ime. It may be the case that a s imi lar trend is underway for pulp f ibre . 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 levels o f harvest, the government has undertaken a series o f po l icy initiatives that can generally be grouped under constraints on harvesting. These include initiatives that w i l l lead to a direct reduction i n what is cal led the \"conventional cut\" w h i c h w i l l physica l ly reduce the amount o f w o o d available f rom C r o w n forest lands, as w e l l as ra is ing harvesting costs by directly mandating certain operational procedures. T h e first set o f po l i cy init iatives can, generally, be grouped as environmental and land use initiatives. T h e government created the C o m m i s s i o n on Resources and the Environment 1 4 4 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 world w i l l need an 8 5 % increase in the production of 164 ( C O R E ) i n 1992, a provinc ia l body charged wi th developing and implement ing a regional l and use p lanning process . 1 4 5 The province also announced the Protected Areas Strategy ( P A S ) i n 1992, p ledging to increase the amount o f parks w i th in B C to 12% of the provinc ia l land area by the year 2000 (by m i d 1999 B C had hit approximately 11.2%). In addit ion, the province has developed specific land use plans for areas such as Clayoquot Sound i n response to pol i t ica l pressure. T h e land use init iat ives can generally be thought o f as an attempt to identify w h i c h areas are considered suitable for t imber harvesting and w h i c h areas w i l l be managed for other priorit ies. In 1993 the province also introduced the Forest Practices C o d e ( F P C ) i n response to environmental concerns about harvesting methods (Province o f B r i t i s h C o l u m b i a , 1994). T h e Code is directly concerned wi th harvesting practices and prescribes i n a very detailed manner how harvesting can be carried out. T h e provinc ia l government has also undertaken a series o f initiatives that can be grouped as forest management initiatives. The most prominent o f these is the T i m b e r Supply R e v i e w ( T S R ) . T h e T S R is being undertaken i n anticipation o f the f a l ldown i n harvest rates as the forest industry moves f rom the exist ing mature forest w i t h higher volumes per hectare into second growth forests that are harvested at a younger age. T o reduce the impact o f the reductions i n harvest rates on what is cal led the conventional A A C (softwood sawlogs) , the government is attempting to increase the harvest i n what i t calls non-conventional types through the part i t ioning o f cutting rights. T h e non-conventional partit ion consists o f deciduous species, smaller wood than tradit ionally has been harvested i n the past, and w o o d that i n the past was considered inaccessible or too costly to harvest. T h e provinc ia l government completed the first timber supply review i n 1997 (termed T S R 1) w i th a negl igible reduction i n the p rov inc ia l A A C o f 1/2 a percent. T h i s , however, was due to pulpwood over the next 50 years and that there w i l l be continued upward pressure on pulpwood prices. Pulp and Paper Week, August 12, 1996, page 5. 1 4 5 C O R E recommended land use plans for Vancouver Island, the Car iboo-Chi lcot in , and the West and East Kootenays. The government incorporated these suggestions in developing land use plans for the area. The Commiss ion is currently quiescent and there are no signs of the government reviving it. 165 the increase i n the non-traditional harvest types (the conventional softwood A A C decreased f rom 66.8 m i l l i o n cubic metres to 63.4 m i l l i o n cubic metres or by 5 .2%)(Timber Supply B r a n c h , 1999). It is anticipated that the ongoing review ( T S R 2) w i l l lead to a greater reduction i n the A A C as the fu l l impact o f increased environmental regulations and set-asides are felt. The provinc ia l government also increased stumpage rates i n M a y o f 1 9 9 4 . 1 4 6 T h e higher rates were designed, i n part, to fend off potential trade act ion by U . S . lumber companies, as w e l l as to fund a set o f po l i cy initiatives that can generally be classified as transition/mitigation (Price Waterhouse, 1995). These include the Forest Renewa l P l a n , the Forest Sector Strategy, and the Forest Jobs C o m m i s s i o n . These are meant to provide assistance to workers f rom j o b losses resulting f rom land use decisions and to develop a strategy for the B C forest sector. Impacts of Forest Policy Initiatives T h e ma in 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 of the available fibre (above and beyond that attributable to the lower y i e ld per hectare). A report commiss ioned by the provinc ia l government showed that the cost o f del ivered logs i n the Interior rose by $32.46 between 1992 and 1996, w h i l e the cost o f logs o n the B C Coast rose by $46.35 ( K P M G 1997). T h e increased cost stems both f rom the increase i n stumpage rates as w e l l as f rom such items as increased road construction costs, due to more stringent design requirements, increased roading as a consequence o f different harvesting practices, and environmental regulations that now require operations to take place i n more inaccessible areas . 1 4 7 Increased costs also arise f rom the increased planning requirements and need for detailed 1 4 6 These rates were reduced in June of 1998 and have been contested under the Canada-US Softwood Lumber Agreement ( S L A ) . A settlement was reached in September 1999 that left rates unchanged but imposed higher export fees for B C under the S L A . 166 harvesting plans. F i rms also lose flexibility i n scheduling their harvest, as planning requirements require the licensee to have drawn up a detailed cutting p lan at least two years i n advance. F i rms now f ind that i f changes i n market prices have changed the desirabil i ty o f their operational p lan (for example, dur ing times o f h igh pu lpwood prices, f i rms m a y choose to undertake thinning or harvest more marginal stands than they otherwise would) , they are l imi ted by the need to obtain regulatory app rova l . 1 4 8 F i n a l l y , the licensee becomes m u c h more constrained i n what they cut on the site and m a y be unable to adjust their harvest profile to market conditions ( in other words, br inging i n addit ional lower grade material or leaving more behind depending on p r i ce s ) . 1 4 9 The net effect o f a l l these initiatives w i l l be to reduce the area available for timber harvesting thereby reducing the amount of 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 more detail i n N e l s o n et a l . (1997), but is sufficient to create a deficit o f residual s a w m i l l chips i n the Interior based on the average historic operating rate for the pulp and paper industry i n the province. Interior pulp m i l l s w i l l l i k e ly look to roundwood chips to meet their f ibre needs. Tenure Policy W h i l e these initiatives affect the cost of fibre, the government also influences the pulp fibre market through its practice o f timber al location. It has been a long-standing feature o f government po l i cy to award long-term cutting rights to t imber processors. In recent years, the government has responded wi th several programs to complaints that it is difficult for operators without cutting rights and new entrants to acquire fibre for processing. T h e most important o f these, i n terms o f size, is the S m a l l Business Forest Enterprise Program ' One case study from the southern Interior suggested harvesting levels would drop by 3 1 % while overall operating costs would increase by 32%, with roadbuilding costs increasing 87% (Thibodeau, 1995). ! The Min i s t ry of Forests has to approve a forest management plan and grant a cutting permit before a licensee is al lowed 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 provides short term cutting licenses. These are awarded on the basis o f either the highest b id or on how w e l l an application satisfies certain criteria such as the amount o f employment created or economic value added to the processed timber. Because most t imber is he ld through long term cutting rights, licensees develop trading relationships and other arrangements wi th other licensees to come up w i t h the best species m i x for their particular m i l l . However , it has been acknowledged that licensees are uninterested i n trading fibre unless they can obtain fibre i n return ( B C M O F 1993). T h e result of this is that there are vir tual ly no substantial quantities o f fibre freely available on the open market. The net effect has been to create a substantial secondary market for fibre that requires participants to have fibre to trade. T h i s is best il lustrated o n the Coast , where the Vancouver L o g Marke t main ly functions as a trading mechanism for participants to obtain desirable species and quality mixes for their fibre. There has been li t t le such trading i n the Interior to date, although pulp m i l l s i n the Interior do engage i n ch ip swaps to both rationalize transportation costs and to obtain certain species mixes . However , such ch ip swaps are on a one-for-one basis; that is , there are reciprocal f lows o f chips w h i c h avoids the need to set prices (Henr icksen 1995). T h e B C government also encourages such secondary trading (not a l l o f i t need take place between pulp m i l l s and sawmil ls) through its po l icy o f al locat ing t imber directly. In some cases, f i rms may apply for a S m a l l Business Sale even though they have no intention o f us ing the logs directly or may even be unable to use a l l the logs they harvest. In fact, the government now permits applicants to apply for timber sales even i f they cannot use the logs directly but show that they can trade the logs for suitable fibre. Such arrangements are l i ke ly to take the fo rm o f long-term contracts or supply arrangements geared towards the particular requirements o f that licensee, further reducing the volumes that may be available on the open market. 168 T h e B C government has also undertaken to award the w o o d that w o u l d previously have been categorized as useable only by the pulp industry. T h i s includes some smal l scale salvage programs, where the applicant enters the logging area to retrieve logg ing waste, and the granting o f t imber licenses for smaller wood (sometimes termed problem forest types). Th i s i n turn reduces the potential supply available to the pulp industry. T h e net effect o f a l l these policies are to further reduce the abi l i ty of market participants to respond to changes i n market condit ions. T o the extent that a l l o f the B C government 's fibre is commit ted, one l i ke ly response o f purchasers is to enter into long-term agreements wi th specific suppliers and to develop their o w n capacity to produce pulp fibre f rom wi th in their o w n cutting rights before turning to the open market. T h e size o f that market is l i ke ly to shrink to the point that purchasers may no longer regard it as a significant source o f supply. T o the extent supply patterns become fixed, prices w i l l trend downwards as that market shrinks i n importance. Stumpage Policy In Chapter 1, i t was noted that the product ion o f w o o d chips has gradually become an integral part o f s awmi l l s ' operations. F i g u r e 2 3 shows the average value o f lumber and chips produced per cubic metre o f l o g input on a quarterly basis, termed Product Value, i n the Interior f rom the third quarter of 1990 through the end o f 1 9 9 8 . 1 5 0 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 period, showing the relative change i n stumpage values over the past seven years. ' Product value was constructed by using the price of S P F random length lumber and mul t ip lying it by .250 (the Lumber Recovery Factor) and adding the chip value (mult iplying chip prices by .15 or the Ch ip Recovery Factor) per cubic metre of log input. Clear ly , this measure would vary widely depending on company-specific products and recovery factors. It should be noted that to the extent a f i rm is operating i n areas with h igh pulp log concentrations that the abil i ty to pay would be shifted downwards significantly (although stumpage charges would also have to be adjusted to reflect min imum stumpage for pulp logs). 169 0> * E 9 0 ft F i g u r e 2 3 . L u m b e r a n d C h i p V a l u e s p e r c u b i c m e t r e o f L o g Input a n d 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 - • — Product Value -®— Stumpage T h e introduction o f 'Super Stumpage ' i n M a y o f 1994 can be clearly seen, w h i c h established higher stumpage rates when lumber prices exceeded certain v a l u e s 1 5 1 . N o t e that even after the stumpage reduction that took effect i n June, 1998, stumpage expressed as a percentage o f product value has been consistently higher over the past four years (1994-98) than i n the previous four (1990 - 1993 ) . 1 5 2 G i v e n the increase i n costs associated wi th the Forest Practices Code , this suggests that the annual margin for stumpage payment i n the s awmi l l i ng industry has shrunk i n recent years (a point echoed by B i n k l e y 1995). T h e impl icat ions o f this phenomenon for ch ip pr ic ing are several-fold. Firs t o f a l l , the stumpage system i n use for the past decade used only lumber prices to determine overal l 1 5 1 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 in the B C Interior. The net effect is to shift the effective rate up over higher prices. 1 5 2 A t the end of 1997, stumpage as a percent of product value was once again around 23%, based on a lumber price of approximately $(US) 300 per M b f and chip prices of $85 per B D U . 170 stumpage levels . 1 5 3 1 5 4 W o o d ch ip prices were used to help distribute charges w i th in the Interior but d id not affect the overal l l e v e l . 1 5 5 T h i s meant that when chip prices increased four-fold between 1994 and 1995, the increase had no effect on stumpage rates although it c lear ly affected sawmil l ' s abi l i ty to pay that stumpage. Discussions w i t h industry participants suggest that the record prices paid for chips helped cushion the effect o f the increased costs discussed earlier i n the face of fa l l ing lumber prices. However , when chip prices fe l l and ch ip shipments were curtailed, some sawmil ls found themselves unable to operate and either closed or reduced shifts as stumpage levels remained unchanged. T h i s was a significant change f rom the previous system (pre-1987) where chip and lumber revenues and costs were used i n determining stumpage. Due i n part to the realization that chip revenues affect a sawmi l l s ' revenue, the provincia l government incorporated chip prices i n stumpage determination when it revised stumpage rates (though i n a somewhat convoluted fashion). The basic mechanism o f the stumpage system remains unchanged, however, and whether or not stumpage rates w i l l be responsive to changes i n economic operating conditions remains an open question ( in large part because costs are s t i l l not taken into account i n determining the overal l level o f charges). Second, chip prices also effect the economics o f marginal operations. Several sawmi l l s stated that during the peak i n chip prices they considered commerc ia l thinning; however, as prices fe l l , they could no longer just ify the operations (Mayes 1995, Pinette 1995). H i g h chip prices also substantially improved the abi l i ty o f sawmil l s to buy wood o n the open 1 5 3 The specific formulas used in determining stumpage are set forth in both the Coast and Interior Appraisal manuals. In addition, there have been several explanatory papers written about the mechanics of the stumpage system. A fairly concise view o f the stumpage system established in 1988 can be found in Deloitte, Haskins and Sells (1988). 1 5 4 This was changed when stumpage rates were reduced in June, 1988. A weighted average of the appropriate lumber index and the index for chip prices i n B C are constructed for both regions in establishing stumpage rates. 171 market, an important consideration where many sawmil ls i n the Interior are increasingly re ly ing o n purchased w o o d . However , when pulp prices f a l l , u t i l iza t ion standards may require f i rms to br ing out w o o d that is uneconomic and that w o u l d be left behind based on the costs o f harvesting and transport. F i n a l l y , because o f the h igh degree o f reliance by the pulp and paper industry on residual chips, l o w lumber prices can influence the avai labi l i ty o f pulp fibre supply since f i rms w i l l shut d o w n when they are unable to operate profitably. T h e abi l i ty o f pu lp m i l l s to offset the effects of lower lumber prices by paying more for their fibre depends o n the state o f pulp markets, and the two market cycles may not necessarily coincide (a h igh pulp market offsetting a l o w lumber market). One consequence i n the past has been government intervention, as noted i n Chapter 1, when sawmil l s lobbied the government to increase ch ip prices i n response to increased stumpage costs dur ing previous market cycles w i th l o w lumber p r i c e s . 1 5 6 1 5 7 The Interaction Between Formula Pricing and Firm Behavior F i n a l l y , formula pr ic ing has been a long-standing feature i n both the Coastal and Interior pulp fibre markets. In the past, i t provided a s imple means o f establishing fibre prices i n the face of abundant supplies o f l o w cost residue that w o u l d otherwise be considered waste. It a l l owed sawmi l l s to receive more revenues when the output price rose. However , 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 min imum rate of 25 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 Minis ter B o b Wi l l i ams dropped several hints during the weekend about government assistance to B . C . ' s hard-pressed lumber industry. . .He said independent sawmills are 'being exploited' by pulp companies which pay low prices for wood chips and that legislative action was one measure o f ensuring a better price.\" (Prince George Ci t izen 1974) ' \"The other controversy in B C (regarding the introduction o f the hew stumpage system i n 1987) surrounds wood chip pricing in the Interior o f B C A l l pulp mil ls in the Interior of B C use wood chips generated as a by-product from sawmil l ing operations. The sawmills would l ike to see chip prices regulated (increased) by the Provincial Government, while the pulp mil ls are resisting such a move. Our sense is that the government does not really want to get involved in chip price 172 effects o f changing supply on p r i c e s . 1 5 8 W i t h a l l types o f fibre becoming scarcer, and relative end product prices changing more qu ick ly , pulp companies may find themselves at a disadvantage to the extent they rely on fixed formulae to establish prices that do not reflect changing relative prices o f available fibre. F o r example , the cost o f residual chips was greater than that o f roundwood chips o n the Coast dur ing parts o f 1994 and 1995. T h i s reflected i n part the fact that some o f the chip contracts were tied to lagged prices o f pulp whi le the roundwood market was reflecting current demand and supply conditions. In some cases companies were unable to adjust their prices rapidly enough and overpaid for their chips where they had made provis ional payments i n the preceding t ime per iod ( K u a n 1997). However , formula pr ic ing , by l i n k i n g the input price o f w o o d chips to the output price for pulp , has the virtue o f reducing uncertainty for the pulp m i l l o f one o f its major costs o f production. Pu lp m i l l s s t i l l largely re ly on the spot market to set prices for pulp , even under long-term contracts, and as noted market pulp prices have been volat i le i n recent years. T h i s practice helps reduce some of the risk f rom entering into fibre supply contracts w i th suppliers . The Effect of Imperfect Markets on Social Welfare A s discussed i n Chapter 2, there is no general rule about what constitutes a Pareto op t imum i n markets characterized by space and market power. Instead, the set o f prices that max imize social welfare depend on the assumptions o f that particular mode l . In the model developed i n Chapter 4, total surplus remained constant: the only difference between the various pr ic ing schemes lay i n how the surplus was distributed among suppliers and between consumers and suppliers. regulation and would just as soon ignore the problem in the hopes that it goes away. This would be the best course of action for a l l concerned.\" (Kerr , 1989). ' Alf red Marshal l is known for characterizing the determination o f prices as akin to that o f the action of two scissors blades on representing demand and the other supply. 173 T h i s means that there are no deadweight losses that are c o m m o n l y associated wi th the presence o f market power. However , there are impl icat ions for the forest industry and provinc ia l economy as a whole arising f rom the historic behavior o f wood ch ip prices w i th in the Interior market. These implicat ions stem from the dual role prices serve both as a means o f al locat ing the surplus generated by pulp and paper production, and i n the signals they send to the marketplace. Wha t may have been the effect o f a non-competitive equi l ibr ium on the Interior market? A s Anderson (1985) has pointed out, when t imber tends to be C r o w n granted and administrat ively priced, the corrective tendency o f increasing t imber prices under market-based systems to signify increasing scarcity is absent. T o the extent prices are distorted, f i rms may make the wrong decisions. Ander son pointed out that one l i k e l y effect w o u l d be towards over-investment, as f i rms w o u l d inaccurately perceive investment decisions as profitable based o n incorrect prices. T o what extent, then, might l o w ch ip prices have led to over-investment w i th in the pulp and paper sector i n B C ? Investment and Estimates of Rent In order to examine the question of whether over-investment may have taken place, it is necessary to have some measure o f the economic performance o f the pulp and paper sector. One such measure is the amount o f economic rent generated wi th in that sector. The definit ion o f Rica rd ian rent, the most c o m m o n rent associated wi th forestry, is that it equals the f inal sale value o f t imber less the costs o f harvesting it. Calcula t ing the available Rica rd ian rent i n the B C forest sector involves estimating the f inal sale value o f t imber by the value o f shipments o f the w o o d products industry and subtracting the w o o d industry's total harvesting costs, and do ing the same for the pulp and paper i ndus t ry . 1 5 9 M u c h o f this data is available on an annual basis f rom Statistics Canada, w h i c h reports expenditures on materials, supplies, and fuel as w e l l as labor expenditures by industry group wi th in the forest sector. However , i t is also necessary to calculate the cost o f capital used i n the industry. T h e standard approach is to estimate the user cost o f capital , wh ich is The 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 choosing a rate o f return w h i c h can include a r isk p remium. F o r these calculations, the average annual pr ime rate plus 2 % for risk was used as the rate o f return. T h e detailed methodology and calculations behind the estimates can be found i n Grafton, L y n c h , and N e l s o n (1998). Ear l i e r work on ly estimated rents i n the so l id w o o d sector o f B C (Copithorne 1979; Percy 1987; Grafton, L y n c h and N e l s o n 1998). W h y might rents exist i n the pulp and paper sector as w e l l ? Pu lp and paper m i l l s i n B C consume some fibre directly (approximately 17% - see T a b l e 5) and resource rents may appear for the same reason they appear i n the so l id w o o d sector. M o r e importantly, as discussed i n the previous chapter, has been the effect o f an \"ar t i f ic ia l\" market equi l ibr ium creating the possibi l i ty o f \"monopo ly\" rents as lower chip prices effectively transferred producer surplus f rom sawmil l s to pulp m i l l s (note that i f sawmil l s had received higher prices this w o u l d result i n higher estimates of the resource rent). F i g u r e 2 4 shows yearly estimates o f rent i n the so l id w o o d and pulp and paper sectors a long wi th the charges for C r o w n T i m b e r . 1 6 0 Several features are immediately apparent, most noticeably the increasing amplitude) o f the estimates for both the so l id w o o d and pulp and paper sector. T h i s i n part is due to the influence o f inflat ion, but also represents the increasing size of both industries, although the so l id w o o d sector has consistently been larger than the pulp and paper sector i n terms of rent. In addit ion, it can be seen that both sectors are reasonably w e l l correlated over most o f the time period i n question, w i th the exception o f the last few years. T i m b e r charges appear fair ly synchronized wi th rent estimates over much o f the per iod wi th the exception o f the past few years w h i c h coincides wi th the introduction o f the C V P system. M o s t noticeable, though, are the large negative estimates for the pulp and paper sector i n the early 1980's and 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. 1 7 5 Figure 2 4 . Annua l Resource Rent in B r i t i s h Columbia by S e c t o r , and T imber Charges in 0 0 0 ' s o f D o l l a r s $3,000,000 $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 $0 ($500,000? 9 p ($1,000,000) ($1,500,000) ($2,000,000) •Solid Wood -® Pulp and Paper Charges 1935 Source: Statistics Canada 25-201; 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 used by the province. T h e 1994-95 rent numbers are estimated and i n current do l l a r s . 1 6 1 E a c h entry represents the cumulative total o f rent or charges for that period. Table 17. Estimates of Rent and Charges over Three Different Periods (in millions of current and constant $) Per iod Solid Wood Solid Wood Pulp & Paper Total Rent Charges Charges As a Rent in Rent in Rent in in Constant in Percent o f Current $ Constant Constant 1986$ Constant Estimated 1986$ 1986$ 1986$ Total Rent 1970-80 1980-87 1988-93 $4 ,426 $2 ,490 $6,713 $8,551 $2 ,362 $5,551 $1 ,422 ($1,477) ($789) $9 ,972 $915 $4 ,762 $3,953 $1 ,385 $3 ,450 4 0 % 1 5 1 % 7 5 % Total $13 ,269 $16 ,464 ($1,336) $15 ,560 $8 ,788 5 7 % 1994-95 (all estimates in current dollars) $3,612 $1,412 $5,024 $3,991 80% .77 can be used as an approximate conversion figure to translate current $ into Constant $. 176 Table 18 presents the same information, exc lud ing pulp and paper rents, on a per cubic metre basis to account for changing harvest levels over the different periods. T h e amount o f rent has, unsurprisingly, varied dramatical ly throughout the years, reflecting for the most part c y c l i c a l changes i n lumber and pulp prices (see Figure 2). W h e n the effects o f inflat ion are removed, 1 recent h igh lumber and pulp prices can be seen to be comparable to those i n earlier years. T h e leve l o f rent col lect ion has dramatical ly increased i n recent years; i n fact, these estimates suggest that i n four of the past eight years, more rent was col lected through t imber charges than was available ( in theory) i n the so l id w o o d sector. C lea r ly , such levels o f rent capture cannot be sustained i n the long run without impl icat ions for capital re-investment. Table 18. Estimates of Resource Rent and Timber Charges on a Per Cubic Metre Basis, 1970-95 Per iod Harvest (millions of m3) Solid Wood Rent in Constant 1986$ / m 3 Charges in Constant 1986$ / m 3 1970-80 7 1 4 $11 .98 $5 .54 1980-87 508 $4 .65 $2.73 1988-93 4 7 9 $11 .58 $7 .19 Tota l / Average 1,701 $9 .68 $5 .17 1994-95 (est. in current $) 152 $23.76 $26.24 The large estimates o f \"negative\" rent for the pulp and paper industry reflect the capital intensity o f the industry and the fact that prices often fa l l to near cash costs during recessions when f i rms are unable to cover their costs o f c a p i t a l . 1 6 2 Over the market cyc le , however , f i rms w o u l d recover those costs g iven that the opt imal l eve l o f capacity existed i n the industry. Persistent losses, however, w o u l d be a s ign for some capacity to exi t the market. Consequences of Uncollected Rent These estimates o f rent also suggest that significant amounts o f rent were not col lected through timber charges over the period 1970 through 1980. A s noted earlier, leaving some rent uncol lected w i l l not affect the level o f output. However , to the extent the remaining rent represents a payment 177 i n excess o f a l l economic costs, those payments may have a l ong term impact . Suggestions that have been made include: higher wages; rent dissipation; X- inef f ic iency ; increased f i r m profi tabil i ty; and excess wood-processing capacity. Examinat ions o f some o f these possibi l i t ies have noted that whi le wages do appear higher i n the forest sector, historic rates o f return for B C companies have been be low their peers for much o f the past decade (Schwindt , 1979; Pearse, 1976; Copi thorne, 1979; Pr ice Waterhouse, 1996). Table 19 shows the rates o f return by product for forestry companies operating i n B C . 1 6 3 Table 19. Return on Capital Employed by Product 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 L u m b e r 7 .6 18.7 6.3 4 .0 (4.0) ' (6.4) 9 .0 28 .8 21 .5 10.5 8.6 Marke t Pu lp 9.5 22 .2 22 .8 20 .4 7 .5 (4.3) (2.1) . (8.1) 0 .5 10.0 (9.0) Newspr in t 16.8 18.3 16.4 4 .0 1.3 (2.9) (4.0) (3.5) (1.2) 5.8 5.3 Source: Price Waterhouse, 1996 One possibili ty is that the rent retained by the firms signified indiv idual ly the marginal profitability of increasing capacity. A l t h o u g h resource rent is a price-determined economic residual f rom an industry perspective, i t appears as a cost o f production to ind iv idua l firms. In the case o f uncollected rent, the excess returns are l i ke ly to be attributed to the other commonly fixed factor, capital , and provide the incentive to expand output by investing i n additional capital . There has been some institutional bias behind this; one means o f increasing harvesting rights i n earlier years was to increase the s awmi l l capacity and apply to the government for the additional w o o d requirements. However , despite the ind iv idua l firm's perceptions, firms i n aggregate faced overal l constraints i n harvest levels . A s early as 1980, M i n i s t r y officials wi th in B C were warn ing o f an eventual fa l l -down effect as harvest levels dropped to reflect the move into second-growth forests 162 £ ) } f f e r e n t assumptions about the interest rate would lead to different estimates. However, even setting the risk premium to 0 still yields negative estimates over the period 1970-93 for the pulp and paper industry in B C . 1 6 3 Background information used to prepare these reports distinguish market pulp production between the B C Coast and the Interior. The 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 ( (Min i s t ry o f Forests 1984). T h e end result has been an over-investment i n capacity, wi th the remaining rent dissipated across now 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 ishing effort unti l returns and the stock are dr iven d o w n to the point where no rent remains. Here , f i rms undertook investments predicated on incorrect assumptions about wood costs that d id not y i e l d a sufficient return. A d d i n g the current estimates o f rent (for the two years 1994-95) to the estimates f rom the previous two periods (1980-87 and 1988-93) show that the pulp and paper industry lost approximately $1.2 b i l l i o n over the entire t ime period. U s i n g the same method, the so l id w o o d sector w o u l d have earned $10.7 b i l l i o n over those 17 years (see T a b l e 16). T h i s result suggests that there has been an over-investment i n pulp and paper capacity i n the province. F r o m the pulp m i l l ' s perspective, increasing capacity appeared profitable at the marg in using the prevai l ing \"market\" prices for residual w o o d chips. Howeve r , f r o m an economic perspective, the \"market\" price for w o o d chips d id not reflect the actual economic opportunity cost o f that fibre. T h e end result was a col lec t ive over-investment i n pulp capacity. T h e implicat ions, then, are quite dramatic. Short term government intervention i n the Interior residual ch ip market, designed to address specific concerns, had unintended consequences even after the government ostensibly withdrew f rom involvement i n the market. A s prices o f chips remained essentially frozen, reflecting the peculiar characteristics o f both the commodi ty and market structure, f i rms d id not receive the types o f signals they otherwise w o u l d reflecting changes i n market scarcity, w i th the result that short-term prospects led , i n aggregate, to long-term losses. 1 7 9 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 Ohta 1993:398) In summary, the pattern o f prices observed i n the B C Interior wood ch ip market over the period 1987 to 1996 cannot be explained by a s imple mode l o f competit ive behaviour. Instead, the leve l and pattern o f prices i n the w o o d chip market reflect both the significant influence of government intervention i n that market as w e l l as non-competit ive behaviour. A mode l o f spatial price discr iminat ion shows how price coordination can effectively lead to non-competi t ive outcomes. In the Interior w o o d chip market, pr ice controls enacted by the government i n the early stages o f the market (from the early 1960s through 1980), coupled w i t h restrictions on who cou ld purchase chips, effectively froze the market. N o indiv idua l purchaser had any incentive to deviate f rom historic supply arrangements so l ong as other f irms also adhered to the same arrangements. In terms o f general economic theory, the results suggest that i n this case, a delivered pr ic ing system reduced effective competit ion by permitting firms to engage i n tacit coordination. T h e model o f spatial price discr iminat ion also showed that these types o f outcomes have the characteristics o f a prisoner 's d i l emma. Such equi l ibr ia can be inherently unstable, especially as firms change their beliefs about the environment i n w h i c h they operate. Var ious empir ica l tests show that prices i n the Interior market were be low those i n other markets, and remained relatively fixed unti l a breakdown of historic supply arrangements. T h i s change i n firm behaviour and beliefs l ed to a rapid increase i n prices as firms reverted to the dominant equ i l ib r ium i n the Prisoner 's d i l e m m a (which i n this case is associated wi th higher prices). W h a t might happen i n the future? There is a considerable degree o f indeterminacy o f chip pr ic ing that is not found i n pu lpwood pr ic ing . W h i l e lumber prices may provide some theoretical f loor for chip prices, the increasing volat i l i ty o f lumber markets, coupled wi th the increased costs noted above, make it difficult to identify the m i n i m u m prices necessary for sawmil l s to remain profitable over the l ong run. T h i s indeterminacy provides a great deal o f scope for bargaining over ch ip prices, w h i c h may be one reason chip p r ic ing has been so contentious i n the past (as seen i n Chapter l ) . 1 6 4 C h i p p r i c ing w i l l continue to be a major issue g iven its role i n affecting the abi l i ty o f sawmil ls to pay stumpage and consequently operate, the importance o f operating levels for stumpage revenues to the government, and the fact that fibre costs are the most significant issue fac ing pulp and paper f irms i n the province today. Cons ider the fact that at historic levels o f product ion o f around six m i l l i o n B D U s annually, a $10 increase i n the price per unit raises revenues i n the Interior s awmi l l industry by $60 m i l l i o n , and these revenues f low straight to the bot tom l ine . A s noted above, residual chips w i l l no longer provide enough raw material for the Interior pulp industry (Ne l son et a l . 1997). W h i l e their avai labi l i ty may vary depending on s a w m i l l operating rates, shipments to the Coast , and the export market, an increasing amount o f fibre has come and w i l l continue to come f rom the ut i l izat ion o f r oundwood chips . In effect, they w i l l act as the surge (or buffer) for pulp fibre supply, m u c h as is the case i n the Pac i f i c Northwest . H o w these fibre sources are developed, however, can have important impl icat ions for the Interior industry. B o t h the inherent market structure, coupled w i t h government po l i cy regarding both harvesting and stumpage, have led to an increasingly inf lexible market. Unchanged, this is l i ke ly to lead to a market that alternates between periods o f relative quiescence and periods o f sharp vola t i l i ty . T h e structure o f the pulp and paper industry, g iven the regional concentration and relative size o f most pulp m i l l s , is conducive to the exercise o f market power. T h i s is offset 1 6 4 A recent issue of Madison ' s Canadian Lumber Reporter alludes to the ongoing tension i n this market with an article entitled \"Ch ip Wars\", which discusses the importance of chip revenues to the sawmill industry without coming to any conclusions (Madison 's , November 29, 1996). 181 somewhat by the part icipation o f other purchasers f rom outside the region, namely the export market and pulp m i l l s o n the B C Coast , al though the export o f w o o d chips, as noted i n Chapter 1, has l ong been a contentious i s sue . 1 6 5 T o the extent sawmil l s and pulp m i l l s continue to focus on chip prices and regard p r ic ing as a zero-sum proposi t ion ( in other words , any increase i n price comes straight o f f one party 's bottom l ine and increases the other's), their relationship w i l l continue to be adversarial. In addition, so long as participants regard the system as being unresponsive or inf lexib le , the government w i l l continue to face pressure f rom both sides as each propose their o w n solut ion to the problems o f p r i c ing and supply. H o w e v e r , as noted i n this thesis, past government intervention has often had unintended consequences, and more intervention w o u l d l i k e l y lead to even less f lex ib i l i ty for participants i n the ch ip market. However , given that chip prices have li t t le impact on production decisions, w h y should po l i cy makers care whether the market is competitive or not? There are several reasons. A s discussed i n the preceding chapter, incorrect prices can lead firms to make incorrect investment decisions. B u t perhaps more importantly, competi t ive markets provide a means o f al locat ing goods and distributing funds that are more responsive than the command and control techniques associated wi th government regulation. A competitive market promotes economic efficiency i n two ways: (a) allocative efficiency; and (b) technical or x-efficiency. In terms of the w o o d chip market, this means that market prices send accurate signals about the ut i l iza t ion o f the resource. Forest po l i cy i n B C has been characterized by a reliance on regulations to achieve economic goals. One o f these goals is improv ing the ut i l iza t ion o f the resource, processing w o o d that w o u l d otherwise be 1 6 5 G i l l i s (1989) notes that debates over the export o f pulp wood in Ontario and Quebec in the first part of the twentieth century were very similar, and notes that the main reason local pulp mil ls 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 volumes. T h i s w o o d may face fu l l stumpage charges or qualify for m i n i m u m stumpage (set at 25 cents per cubic metre). In addit ion, the volumes harvested may or may not count against a l icensee 's a l lowable cut. However , it has been shown that such ut i l izat ion standards may require firms to br ing i n uneconomic material ; that is , the fibre costs more to harvest and transport than i t is wor th (Uh le r and M o r r i s o n 1986). A t times, the costs associated wi th processing such material can lead to a curtailment i n logging activi ty, as firms cannot profitabili ty process the whole stand g iven the ut i l izat ion constraints. Another characteristic o f an efficient market is its abil i ty to equilibrate demand and supply. In a freely open market, prices adjust to br ing supply and demand into balance. Because m u c h o f the t imber wi th in B C is tied up i n long term cutting right, there is not much available on the open market. T h i s reduces the abi l i ty o f participants to turn to that market to meet their needs. The practice o f granting long-term cutting rights to specific facilit ies also frustrates the k i n d of responses that w o u l d be expected under competi t ive markets. F o r example , the Kraf t process requires twice the amount o f pu lpwood per unit o f output compared to the mechanical pulp process. It may be that swi tching pu lp ing processes w i l l be one o f the ways the pulp and paper industry adjusts to the decreased avai labi l i ty o f fibre. T o the extent volumes are tied up i n tenures committed to certain facili t ies, these type of adjustments w i l l be retarded. A n example o f some o f these forces at work can be seen i n the short-term collapse of the pulp l o g market on the Coast i n 1996 (Truck L o g g e r 1996). Integrated companies on the B C Coast , fearing a potential shortfall o f pulp fibre during the market peak i n 1995, imported significant quantities o f pulp logs f rom outside B C as that was the only market that cou ld provide significant vo lumes qu ick ly . Howeve r , when pulp prices col lapsed, firms found themselves wi th soaring inventories and the domestic market for pulp logs came to a vir tual standstill (Truck Logger , 1996). T h i s i n turn led to a sharp reduction i n logging, and calls for the government to reduce stumpage until the pulp l o g price recovered as prices for pulp logs were less than their harvesting costs. In some case, f i rms continued to import fibre that was now substantially more expensive than domestic f ibre. T h e same cal ls for changes i n stumpage have been made i n the Interior, where f i rms wi th a h igh proportion o f pulp 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 should face reduced stumpage charges to reflect their relatively higher cost and lower valued t imber stands (although under the current system such proposals w o u l d s imply increase charges w i th in other regions o f the province) (Repap 1996). Ano the r benefit f rom competit ive markets is that f i rms, i f they feel w o o d chip volumes are freely available on the open market, w i l l carry less inventories, reducing the amount o f capital tied up whi le improv ing the quality o f the pulp produced. T h e provincia l government has a c l a i m to the rents generated by the forest industry through stumpage payments. Because most of this stumpage f lows f rom the pr imary processors, sawmil l s are responsible for paying most o f the stumpage. A t the same time, the stumpage system does not use pulp fibre revenues to establish the leve l o f charges . 1 6 6 Despite the advent o f market pulp made f rom de-inked paper and the development o f new plantations, the consensus wi th in the pulp and paper industry appears to be that when cyc l ica l changes are ruled out that fibre costs w i l l continue to increase. Increased w o r l d trade i n fibre is expected as supplies decrease wi th in traditional processing areas. A t the same time, technological advances permitting the use o f lower grade pulp i n paper-making 1 6 6 This may change with the introduction o f new stumpage calculations. However, modification o f the current system depends in part on the impact it may have on the Softwood Lumber 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 abil i ty 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 remium for their higher quality pulp. A t the same time, it is reasonable to expect that a larger proport ion o f fibre w i l l be f l owing into the pu lp and paper sector given a decline i n w o o d quality. Under such circumstances, it is l i k e l y that i n the future the government may seek to establish a stumpage system that uses pulp fibre values. A g a i n , a competi t ive market provides an accurate assessment o f those va lues . ' 6 7 Fina l ly , competi t ive markets also play a distributive role. A s noted earlier, a feature o f the mode l developed was that total production remained unchanged between the various equi l ibr ia , but the distribution o f the surplus changed dramatical ly. F r o m the perspective of a s awmi l l , higher chip prices are an unal loyed benefit, improv ing their bot tom l ine , w h i l e a pulp and paper m i l l sees them as wreaking havoc on their bottom l ine , turning them into uneconomic producers. A s noted above, the government also has an interest i n any rents generated by pulp and paper production. St igler (1971), i n his seminal work , advanced the i theory that most government regulation is a response to agents attempting to further their economic interests. Forest po l i cy i n B C has long been marked by pol i t i ca l c la ims to the wealth generated by the forest (Marchak 1983; Schwind t and Heaps 1 9 9 6 ) . 1 6 8 G r o u p s establish c la ims to the resource rent through attempts to influence government involvement i n the al location and pr ic ing o f fibre, and the pulp fibre market is no different. Compet i t ive markets provide a means o f al locat ing and pr ic ing fibre, relatively free f rom costly pol i t ica l involvement . In terms o f po l i cy recommendations, the results suggest that i n general the government should m i n i m i z e its direct regulation o f the w o o d chip market, and i n particular, any 1 6 7 Accurate values for pulp fibre also are important in determining appropriate transfer prices. This 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 in a joint venture elsewhere, a l lowing for the companies to shift profits between different jurisdictions. A n example of this is the dispute between Crestbrook Pulp and Paper and Revenue Canada (Pratt and Urquhart, 1994). 1 6 8 B C is by no means unusual. Hansing and Wibe (1992) show how laws meant to ration timber in Sweden have helped the existing industry to deter entry. 185 regulations having to do wi th p r i c ing and/or restrictions o n where w o o d ch ip producers can market their chips. The evidence suggests that the Interior market can function competi t ively (given the exist ing market structure during the study pe r iod ) . 1 6 9 T h e existence o f a large market for wood chips, not often present elsewhere i n Canada, offers an opportunity for po l i cy makers to help establish competi t ive prices for pulp f ibre. T h i s offers many of the advantages outl ined above, as w e l l as provid ing more reliable values that can be used i n decis ion-making. F o r example, the government has indicated a preference for more intensive si lvicultural treatments. Because o f the l ong time frame invo lved , the economic payoffs tend to be marginal . One o f the ways i n w h i c h these treatments can become profitable is through the use o f various thinning techniques that provide volumes o f wood earlier i n the treatment period than the standard practice o f harvesting at maturity. Recogn iz ing the true economic value o f this f ibre, much, o f w h i c h is suitable for pulp ing , w i l l help to determine where such treatments are feasible. In addit ion, the choice o f end-product m i x (for example, the proport ion o f sawlog versus p u l p w o o d quality t i m b e r ) is also dependent on the relative values o f the products invo lved . Another consideration the government faces is i n establishing the trade-offs between the benefits and costs o f environmental regulation i n the forest industry. F o r example , the government is currently considering regulations that stipulate how m u c h debris should be left on site after logg ing operations (this coarse woody debris being considered is different f rom the ut i l iza t ion standards currently i n place). Some o f this debris m a y be suitable for pulp fibre, and to the extent the government restricts f i rms f rom u t i l i z ing it , i t places additional pressure on maintaining harvest levels . Establ ishing appropriate values w i l l a id i n mak ing these kinds o f decisions. T h e government is l i ke ly to continue its tradition o f encouraging economic development through granting access to w o o d fibre. Howeve r , m u c h o f the uncommit ted w o o d fibre 1 6 9 This includes ownership patterns, the number and distribution of pulp mil ls and sawmills, control of cutting rights, and harvest levels. 186 remaining today is non-conventional (e.g. i s smal l , c rooked, or insect-damaged); the pulp and paper industry is one o f the most l i k e l y consumers o f such fibre. T h i s thesis has also shown that market power is a perennial concern throughout pulp fibre markets i n Canada (Geldhart and C a r r o l l 1980, O l s o n 1989, R u n y o n 1983, Nau t iya l et a l . 1995). I f pulp and paper firms receive access to fibre through long-term commitments such as pu lpwood agreements, market concentration and the potential for the exercise o f market power can be expected to grow. T h e government should encourage the development o f additional sources o f fibre outside o f integrated companies and should not permit the ut i l iza t ion o f unused P u l p w o o d Agreements . T h e provinc ia l government may also want to review its pol ic ies on pr ic ing for pulp fibre, recogniz ing that historic prices may not be a good predictor for future pr ic ing . T h e tendency i n the past, as noted i n Chapter 1, has been to mechanical ly l i n k charges to output prices. T h e government should also take into account the variabi l i ty i n end-product prices i n designing an appropriate system of charges, recogniz ing that the abi l i ty to pay for pulp fibre differs substantially over the market cycle . T h e government should also develop a consistent export po l i cy . T h e current practice o f on-again, off-again exports min imizes the benefits o f having an effective market outlet for suppliers, as foreign customers regard B C chips as unreliable and price them accordingly. A s discussed above, analysts have forecast increasing prices i n the global marketplace for pulp fibre. A c c e s s to this market offers the possibi l i ty o f increased competi t ion i n the provinc ia l pulp fibre market and could offset the effects o f loca l concentration. I f the province reduces the abil i ty o f f i rms to participate i n the export market, domestic chip prices w i l l be lower i n the long run. T h e issue o f whether or not residual chips should be retained to provide fibre supply for domestic pulp m i l l s is another manifestation o f the mercanti l ist 's debate about provid ing jobs by restricting imports ( in this case, exports). A s M a r g o l i c k and U h l e r (1992) show, these pol ic ies provide direct benefits to the processors ( in this case pulp mi l l s ) but the benefits are outweighed by the losses suffered by the producers and the government. T h e benefits o f the export market i n provid ing a competi t ive 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 po l i cy o f retaining fibre for domestic use has been an over-investment i n pulp and paper capacity. Restr ic t ing exports now w i l l not address the fundamental issues under lying the long-term competitiveness o f the pu lp and paper industry i n the province. F ina l ly , there has to be a recognit ion that the defini t ion o f pulp fibre is a lways changing due to new technology. It depends o n the particular type o f f ibre, species i n v o l v e d , locat ion , transportation infrastructure, processing capacity, and market condit ions. F o r example, o n the B C Coast, smal l logs can either be chipped or sawed, depending o n the state o f the lumber and pulp markets. T h i s presents difficult ies i n B C , where the tenure system is designed to provide w o o d fibre to specific end users and then to calculate the appropriate charges. T h e government should strongly resist the temptation to create or tie w o o d volumes to specific uses and/or licensees and instead, increase the amount o f w o o d that can be brought to the open market that is uncommitted. In turn, the prices der ived f rom open-market purchases w i l l help send the appropriate signals about the ut i l iza t ion o f the t imber resource to companies, and also help f irms and the government to establish competi t ive prices for pu lp f ibre. T h e potential role of the export market in increasing competition by a l lowing alternative markets has been recognized within the industry since the first debate over a l lowing pulpwood exports from Canada to the U S in the early 1920's. 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Quarterly. Seattle. Y o u n g , B r u c e . 1975. L icke ty - sp l i t freight haul ing chips south. British Columbia Lumberman. M a r c h : 78 . Y o u n g , B r u c e . 1975. O n the road wi th Bruce Y o u n g . British Columbia Lumberman. November : 54. 205 Appendix A. Data Sources Several different data sets and sources were used to construct the tables and figures w i th in this thesis. W h i l e some data does exist i n the pub l ic domain , m u c h o f i t is not pub l i c ly reported. Some of the most detailed data is on ly available o n a proprietary basis. T h i s appendix discusses those data sources used that are not easily available. Ministry of Forests Data Set on Wood Chip Transactions T h e stumpage system introduced by the province i n 1997 requires information on end-product values for sawmil l s i n the Interior. Consequently, the Revenue B r a n c h wi th in the M i n i s t r y o f Forests started col lect ing information o n w o o d chip transactions i n December 1986. T h e government attempts to collect a l l arms-length transaction between buyers and sellers i n the Interior o n a monthly basis, i nc lud ing sales outside the region. Starting i n 1994, the government discontinued its po l i cy o f identifying specific purchasers and instead reported transactions solely on the basis o f the supplier 's locat ion. Table A. 1 shows the total number o f transactions i n the data set, by month. T h i s includes reported sales to F ibreco; these sales and others to infrequent purchasers were omitted i n the data set used to evaluate price levels and patterns i n the Interior. A substantial number o f transaction were reported for sales to F ibreco ; however , these values var ied w ide ly , reflecting the use o f ch ip sales by members to pay off loans incurred i n the construction o f the Fibreco pulp m i l l , resulting i n a reduction i n apparent chip prices. T h e government over this t ime frame found the prices too be unreliable and d i d not use the prices i n calculat ing stumpage charges. T h i s data was provided under conditions o f strict confidentiali ty. 206 Table A.l . Ministry of Forests data Year Mon ths Transactions 1987 7 134 1988 6 445 1989 5 263 11/89-10/90 12 816 11/90-10/91 12 676 11/91-10/92 12 6 8 4 11/92-4/93 6 341 5/93-4/94 12 749 5/94-7/94 3 185 Total 7 5 4293 Table A.2. Sawmill data Y e a r Mon ths Data points 1/95-2/96 , 14 7 0 Supplementary Data on Wood Chip Prices A s noted above, the government no longer identif ied specific purchasers starting i n 1994. In order to extend the data set, a series o f interviews were carried out through the Interior i n the summer o f 1996. Industry participants were able to provide information on prices pa id by the five largest purchasers i n the Interior f rom the beginning o f 1995 through the first two months of 1996. T h e information was only available as an average price pa id by the purchaser and not as ind iv idua l transactions. 207 Chip Audit Task Force Report T h i s report has been circulat ing for at least twenty years. It is w e l l - k n o w n w i t h i n certain parts o f the forest industry (certainly the pulp and paper industry). It is an extremely valuable source o f information i n terms o f p rov id ing data o n consumption and product ion for one region i n the Interior. A n industry participant k i n d l y loaned me his copies for the period f rom 1987 through 1996, under conditions o f strict confidentiali ty. Woodfibre Northwest T h i s quarterly publ icat ion based i n B o t h e l l , Washington, tracks pulp fibre prices throughout Western Nor th A m e r i c a . The publisher generously gave me permission to use certain historic data series on prices for various markets wi th in the region. Economics and Trade, Ministry of Forests T h i s branch o f the M i n i s t r y tracks annual product ion and consumption o f pulp fibre i n the province. W h i l e the results are not pub l i c ly released, they are available to the publ ic . In addit ion, this branch can provide information o n ch ip exports, as w e l l as informat ion o n different measures o f product ion for various parts o f the forest industry. 2 0 8 "@en ; edm:hasType "Thesis/Dissertation"@en ; vivo:dateIssued "1999-11"@en ; edm:isShownAt "10.14288/1.0099421"@en ; dcterms:language "eng"@en ; ns0:degreeDiscipline "Forestry"@en ; edm:provider "Vancouver : University of British Columbia Library"@en ; dcterms:publisher "University of British Columbia"@en ; dcterms:rights "For non-commercial purposes only, such as research, private study and education. Additional conditions apply, see Terms of Use https://open.library.ubc.ca/terms_of_use."@en ; ns0:scholarLevel "Graduate"@en ; dcterms:title "Spatial pricing patterns and market power ; Theory and evidence from the BC interior pulp fibre market"@en ; dcterms:type "Text"@en ; ns0:identifierURI "http://hdl.handle.net/2429/10063"@en .