Long Exam in Forest Resource Economics and Evaluation PDF

1 FMgt 147n: Forest Economics and Valuation First Semester 2024-2025 INTRODUCTION TO FOREST ECONOMICS FORESTRY FROM AN ECONOMIC VIEWPOINT Forests are economic res...

1 FMgt 147n: Forest Economics and Valuation First Semester 2024-2025 INTRODUCTION TO FOREST ECONOMICS FORESTRY FROM AN ECONOMIC VIEWPOINT Forests are economic resources because we can use them to help produce goods and services that people want to consume. This is the definition of economic resources (or “factors of production,” as they are called in economics textbooks) – things in limited supply that can be combined with other things to produce products and services that consumers want. Thus, we can make use of a forest, combined with some labor and other inputs, to help produce consumer products such as housing, newspapers, fuel wood, outdoor recreation, and environmental services. It is this usefulness of forests that makes them valuable economic resources. The more value in final goods and services that can be generated from a tract of forest, the more valuable is the forest itself. Usually there is more than one way in which a forest can be used, and someone must choose from among them. The timber might be harvested and used for making lumber, paper, or fuel wood. It might be kept standing, to support recreational or aesthetic values or environmental services, or it might be saved for industrial use by future generations. Often, a forest can generate two or more kinds of benefits simultaneously or sequentially – such as industrial timber, recreation, livestock forage, wildlife habitat, flood control, and carbon storage – in which case, someone must choose the preferred combination and pattern of uses. In all cases, choices must be made about how a forest will be managed, what goods and services will be produced, how much will be invested in enhancing growth or conservation, and so on. Economics is the study of such choices, specifically the choices that determine how scarce factors of production are allocated among their alternative possible uses to produce useful goods and services. In other words, it is a science of decision making or the study of how individuals, firms, and societies decide how scarce resources are used. To illustrate how economics can help individuals make decisions, take the example of college students. Students go to college with one or a few objectives, such as having a good education and getting a good job. On a daily basis, all students have a limited or scarce resource – time. How to allocate time every day is critical to whether students can achieve their goals. Each day, students have several things to do: study, work, engage in sports, relax (for example, by watching TV, facebooking), and socialize. The economic principle that guides them in allocating their time is that the marginal utility (satisfaction) of allocating the last unit of time to each activity should be equal. In this way, the students get maximum possible utility (satisfaction). Doing this consistently is likely to make them succeed in college. These last few sentences demonstrate the efficiency rule that is developed later. Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  2 Forest economics deals more narrowly with choices about how forests are managed and used; how other factors of production, such as labor and capital, are used in forest production, utilization, and conservation; and what and how much forest products are produced and marketed. Forest economics applies the discipline of economics to decision making in forestry and covers the whole forest sector. Forest economics can be approached from several directions. First, the focus of attention here is the forestland, the timber, and other goods and services produced directly from forests – the economics of forest resource management. We also deal briefly, however, with the manufacturing and marketing of secondary forest products, such as lumber, plywood, and paper, because the demand for primary forest products such as timber is driven by the value of these secondary products. Second, our judgments about economic performance are made from the viewpoint of society rather than that of individual forest owners or producers. The criterion we adopt for assessing the economic advantage of one activity over another is a comparison of the net gain, the surplus of benefits over costs, that accrues to society as a whole, taking into account relevant concerns about the distribution of the benefits and costs. This is important because the economic interests of individual entrepreneurs, landowners, workers, or forest users often diverge from that of society collectively. Third, we shall assume throughout that the broad purpose of forest management and the production of forest products is to generate the maximum net gain, or value to society. This assumption is important because much of the literature on forest management assumes, or at least implies, different objectives, such as production of the maximum possible quantity of wood, maximum profits to producers, or stability of harvest rates. Such different objectives have an important place in forestry traditions and, as we shall see, have profoundly influenced forest policies around the world. It is important to recognize, however, that narrower objectives such as these inevitably conflict, to a greater or lesser extent, with the goal of maximizing the forest’s economic contribution to society as a whole. The value that a forest generates for a society can take a variety of forms. Some of these, such as industrial timber, are ordinarily marketed and their value is reflected in their market prices. Others, such as aesthetic benefits and some forms of recreation, are usually provided free, so there is no market indicator of their value. Moreover, while the market values of products like timber are critical to a private company, many non-market benefits of forests are also important to private landowners as well as the public. For example, for many small private forest landowners in North America and Europe, the non-market recreational values of their lands are the primary motivation for owning the land and timber values are secondary. Indeed, a complex range of market and non-market values is a common aspect of forestry almost everywhere in the world. In the forested areas of developed countries, in regions such as British Columbia, Oregon, and Washington, the important values for most landowners may be timber and recreation. In developing countries like Nepal or Philippines, the important values may be construction timber and poles, fruit, and fuel wood; the first two are usually sold in markets, while the latter two are often unmarketed and consumed in homes. Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  3 The important point is that in assuming the viewpoint of society as a whole, we must take unbiased account of the full range of social benefits, whether they are priced or not. Even for most private landowners, we must account for a range of both priced and unpriced benefits from forests. We also have to focus on the problems of evaluating environmental and other non-market benefits, trade-offs among uses, and multiple use. Forest values are classified into two main categories (Figure 1.1). One of these is extractive values, which involve physically harvesting and removing resources for use outside the forest; these include not only the familiar timber, poles, and fuel wood but also minor products such as mushrooms, fruit, rattan, bamboo, livestock fodder, and game. The other main category is non-extractive values, which are realized without extracting resources from the forest, and are further divided into two subcategories: ecosystem services, such a soil and water protection, biodiversity, and climate modulation; and preservation values, which refers to the value that people place on preserving forests in their present state. Recreational or cultural uses of forests can have extractive value (such as hunting and fishing), non-extractive value (such as birdwatching and hiking for relaxation and spiritual renewal), or both. Although not explained in detail in Figure 1.1, it is useful to distinguish three types of preservation values: existence value, option value, and bequest value. Existence value is the value that people place on preserving forests from human disturbance for the continuing benefit of future generations; this is the value most often associated with protecting environmentally sensitive forests in their natural state as a park or some other secure form of protection. Option value is the value that forest owners or others may gain from preserving a forest in the present to maintain the option of harvesting it in the future. Bequest value is the value that people derive from bequeathing forests in their present form to future generations. The boundaries between these categories are often unclear and inevitably overlap. Scholars and others use terms like “ecosystem services” and “preservation values” in various ways. The most broadly encompassing definition of ecosystem services is that of the United Nations 2004 Millennium Ecosystem Assessment, which embraces all benefits that humans receive from managed and natural ecosystems – that is, all the values listed in Figure 1.1. For this class, however, it is useful to distinguish these values to draw attention to the different challenges they present for measurement and for making trade-offs among them in forest management decision making. Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  4 Figure 1.1 A forest’s economic value. As a final observation on the values derived from forests, it is worth noting that some biologists and philosophers argue that forests have intrinsic value independent of their instrumental value or usefulness to human beings, and so an economic valuation is too anthropocentric to capture their full value. Human values are undoubtedly influenced by ethical and moral norms, however, especially as these apply to nature, and whether there are values beyond this – or a practical method of measuring them – is unclear. In any event, we will focus on the economic value of forests, defined broadly to include all their identifiable priced and unpriced values, to guide forest management decisions. BASIC ECONOMIC QUESTIONS An economy consists of production, consumption, investment, and other activities linked by a huge number and variety of transactions taking place continuously. The bewildering detail and complexity of an economy can, however, be visualized in terms of a few straightforward processes. On the one hand, the society being served by the economy has certain wants. People want goods like food, houses, car or motorcycle, and services like medical care and recreation. Their welfare or standard of living is measured by the extent to which these wants are met: the more people’s wants are satisfied, the better off they are and, since no society has ever been known to be fully satisfied, welfare is always a matter of degree. It is important to note that people’s wants extend beyond strictly private desires to collective or public concerns about economic security, equity, and freedom. On the other hand, any society has a limited capacity to produce the goods and services that will satisfy these wants. The wherewithal to produce these consists of natural resources (or natural capital); human-made capital such as machines, roads, and other infrastructure; labor; and technical knowledge. All of these change over time, but at any point in time they are finite. Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  5 The function of the economic process is to determine how these limited resources are used to satisfy some of the unlimited human wants. Thus, economics is the study of how scarce resources are allocated among competing uses. Every society must deal with three fundamental economic questions. Given its limited endowment of productive resources and the unlimited wants that they must serve, a society must somehow make decisions about: which goods and services, of the almost infinite variety that it is technically possible to produce with these resources, will actually get produced, and in what quantities which of the variety of technically possible ways of producing each good and service will be adopted in each case how the goods and services produced will be distributed among members of the society. These basic questions are answered in every economy, but in different ways. Primitive, subsistence societies rely heavily on custom and tradition to make decisions about what to produce, and how. Socialist systems rely primarily on central planning and governmental direction. The capitalist system depends on market forces generated by the independent actions of individual producers, consumers, and owners of productive resources. A mixed capitalist system utilizes market forces as well as government intervention. Nowadays, pure socialist and pure capitalist economies are rare. Rather, most countries have adopted mixed capitalist and socialist systems, which depend on varying degrees of government participation and intervention in markets. Any study of the economics of forestry must take careful account of the character of the economic system within which forestry is being practiced because this governs the issues that need attention. A socialist or subsistence economy raises quite different problems from a capitalist one. In a typical form of “mixed capitalism,” most production is organized and carried out by private entrepreneurs responding to market incentives. Governments play an important role in regulating economic activity, however – providing a variety of services, manipulating prices and incentives, redistributing income and wealth, and managing the general level of economic activity. MIXED CAPITALISM AND THE ROLE OF GOVERNMENT In a market economy, entrepreneurs take responsibility for producing things. They occupy the interface between suppliers of productive resources and purchasers of final goods and services. Entrepreneurs purchase the resources they need in order to produce the goods and services desired by consumers, and the prices they pay for these resources determine the incomes of those who provide the resources. The first of the three basic economic questions referred to earlier – what should be produced – is therefore determined in the first instance by consumer demand, hence the concept of “consumer sovereignty.” The second question – about how the output will be produced – is determined by constant competition among Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  6 individual producers to find the most cost-effective means of production in order to enhance their profits. And the third – concerning the allocation of the fruits of production – is resolved by the distribution of income, which in turn is governed by the market values of the labor, capital, and other productive resources that private suppliers make available to producers. In the mixed capitalist system typical of most countries in the world today, however, governments intervene in these processes and change the pattern of production in important ways. They provide not only the traditional public goods (such as roads, lighthouses, and national defense) that private producers do not normally produce at all but also an increasing variety of goods and services that private producers produce inadequately. Such things as health care, education, and the arts fall into this category of merit goods, which have a social value exceeding their value to individual consumers. Some governments even produce indus- trial timber, a seemingly pure private good. More importantly, governments indirectly influence private production and consumption by means of taxes, subsidies, and regulations. Governmental regulation of activities ranging from marketing to safety procedures for workers affects industrial structure, output, and prices. All these forms of intervention that alter the way in which productive resources are allocated and used comprise the allocative role of government. Governments also substantially affect the distribution of wealth and income. Taxes, government spending programs, transfers, and borrowings of various kinds all redistribute income within and among socioeconomic groups, regions, and generations. Sometimes these redistributional effects are deliberate and obvious, as when pensions are paid to the senior citizens, but often they are subtle and indirect, requiring complex analysis to trace their full impact. This is the distributive role of government. Finally, modern governments accept responsibility for maintaining a stable level of economic activity. This calls for fiscal policies (spending and revenue-collecting programs) and monetary policies (manipulation of interest rates, exchange rates, and the supply of money) to offset trends towards inflation or unemployment. Related to these stabilization activities are policies for promoting economic growth and regional development. These comprise the stabilization role of government. By intervening in various ways, governments attempt to correct some of the weaknesses and inadequacies of the market system. Expressed in another way, government intervention in the form of allocative, distributive, and stabilization measures reflects efforts to improve the performance of the economy in terms of achieving the economic objectives that a society sets for itself through the political process. In studying the economics of forest management, we find ourselves continually confronted with government policies aimed at influencing the way forest resources are developed, managed, and used. The primary objective of some of these policies is to improve efficiency by affecting the rate and pattern of resource use. Other policies are motivated by dis- tributional or equity considerations, or a desire to manipulate community and regional growth. Whatever their primary purpose, all forms of intervention inevitably have implications for all three of the fundamental forms of economic impact, namely, the Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  7 allocation of resources, the distribution of income and wealth, and economic stability and growth. ECONOMIC OBJECTIVES: EFFICIENCY AND EQUITY The allocative, distributive, and stabilization roles of government imply two fundamental economic objectives of society: efficiency and equity. These objectives provide us with criteria for assessing economic performance. In any society, there is a presumption, more or less qualified, that the primary objective of economic activity is to satisfy consumer demands to the greatest extent possible. The extent to which these demands are met with the available resources is a measure of the efficiency of the economic system. At the macroeconomic level, if resources were employed in one sector of the economy when they could generate greater value in another, it would be possible through some reallocation to increase the value of total output and hence the efficiency of the total system. In that case, the gross domestic product (GDP), the total value of all goods and services produced in an economy in a year, which is often used as a first approximation of an economy’s performance, would be increased. Similarly, at the microeconomic level, an inefficiency exists if a producer fails to employ an available technology that would enable him to produce more with the same amount of inputs. Thus, economic efficiency refers to the allocation of resources that generates maximum value from the resources used. The level of economic efficiency is reflected in the relationship between inputs and outputs: the greater the output relative to input, the greater the efficiency. In economic analysis, efficiency is expressed as the ratio of benefits (outputs) to costs (inputs), both measured in the common denominator of dollar or Peso values. Of course, a thorough economic analysis from the viewpoint of society as a whole must account for unpriced benefits and costs as well as those that are more readily observed and measured in market prices. Efficiency in economic activity is therefore a logical social objective. Unless there are offsetting considerations, the use of any resource in a way that generates less value than it is potentially capable of generating through some other uses is simply a waste, lowering the value that society derives from its resources. How forests can best be used in light of the variety of demands on them is one of the central questions of economic efficiency in forestry. A second question concerns the intensity of forestry – that is, how much labor and capital can be advantageously devoted to utilizing and managing forests to increase production. There is also an important temporal dimension to economic efficiency in forestry, referring to the pattern of investment and utilization of the resource over time. Because forests take so long to grow and can be harvested over such a broad span of time, this temporal dimension of efficiency is especially important in forestry. Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  8 Market economies give producers incentives to operate efficiently and thereby compete successfully. On the other hand, various distortions and market failures, or failures of prices and the need for corrective policies to reflect society’s real preferences, give scope for governments to improve efficiency through their allocative, stabilization, and growth- stimulating activities. Equity refers to fairness in the distribution of income and wealth, and therefore the fruits of production, among the population. As noted above, the distribution of income is determined, in the first instance, by payments for the factors of production. It can be altered to a preferred pattern, however, through taxes, subsidies, transfers, and other types of distributive intervention by governments. Like efficiency, equity invites a comparison of possible alternatives to determine which, of all the possible distributions of income and wealth, best serve society’s preferences. Also, like efficiency, equity has more than one dimension. Interpersonal equity refers to the distribution of income among individuals at any time. Equity among people living in different geographical regions is referred to as interregional equity. And intergenerational equity refers to the distribution of income among people living at different times. All these dimensions of equity are relevant to forest policy. In forestry, questions of equity often relate to the needs of poorer people or poorer regions, or to conserving forest resources for future generations. Both efficiency and equity are difficult to measure. Efficiency is usually measured in dollar terms: the value of outputs relative to the cost of inputs, both of which are often reflected in market prices. Market prices are sometimes misleading, however: some benefits are not traded in markets, some costs exceed the amount of compensation paid, and other distortions and market failures make it necessary to supplement market price information with estimates of social values in order to assess efficiency. Equity, which rests on subjective judgments about fairness in the distribution of income and wealth, defies empirical measurement except through political processes and ethical judgments. For example, a policy that makes disadvantaged people worse off is often considered inequitable, but that might not be so if it serves some other social objective, such as a desired regional redistribution of income or benefits to future generations, all of which are difficult to measure and compare. It is important to note that the objectives of efficiency and equity often come into conflict, and it becomes necessary to sacrifice one for the other. For example, measures that could expand output (increase efficiency) might create unwanted changes in the distribution of income (decrease equity), and vice versa. This illustrates the trade-off between improvement in equity and aggregate production, and the choices that must be made. The relative priority of objectives and the appropriate compromises among them are not matters that can be solved by economic analysis. Political and electoral processes must be depended upon to prescribe the appropriate mixture of allocative, distributive, and stabilization efforts on the part of governments and to reconcile divergent opinions about equity and efficiency. Economic analysis can provide guidance in making these decisions, however. This “discussion” places heavy emphasis on the efficiency of resource allocation, especially the economic efficiency of forest resource development and use. This is not to suggest that Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  9 concerns about equity and stability are unimportant in forestry; on the contrary, we shall see that some of the most profound issues in forest management, issues that have motivated significant forms of governmental activity, have to do with distribution among groups and regions and economic stability over time. We emphasize the efficiency of resource allocation, however, for two reasons. One is that it provides a necessary starting point for examining the benefits and costs of governmental policies and programs that change the distribution of income, promote economic growth, or affect market outcomes in other ways. The second reason is that from the viewpoint of an economic analyst, much of the uniqueness of forestry, as distinct from other forms of economic activity, centers on problems of efficiency. FORESTS AS ECONOMIC RESOURCES In economics, the general term “resources” refers not only to land and natural resources but also to capital, labor, and human skills that are valuable in producing goods and services. The essential characteristic of an economic resource is that it is “scarce,” in the sense that there is not enough of it available to satisfy all demands for it. It is this scarcity, or limitation of supply, that raises problems of choice about how resources are to be allocated. It also makes them valuable, even though their value in some uses is not reflected in market prices. Not all forests are economic resources in this sense. Some are so inaccessible, so remote, or of such poor quality that they are not demanded for any economic purpose, even though they might provide environmental benefits. Having no economic value or alternative uses, such forests do not present the usual problems of choice and allocation among competing uses that are associated with economic resources. Most forests, however, are capable of yielding one or more products or services, and so they constitute part of an economy’s total endowment of productive resources. It is this economically valuable part of the total physical stock of forest that we are concerned with in forest economics. An economy’s total endowment of productive resources is commonly divided into four broad categories: land, labor, capital, and entrepreneurship. Each of these has distinctive economic characteristics, and each generates economic returns of a different kind, namely, rent, wages, interest, and profit, respectively. Forest resources fall into two of these categories. The basic resource is the forest land, which has the same economic characteristics as agricultural and other land. In any location, it is fixed in supply; it varies in productive quality; and it generates a residual value, or rent, that varies accordingly. The forest itself, consisting of trees on the land, falls into the category of capital. It can be built up over time through investment in silviculture and pest control, or it can be depleted through harvesting; it derives its value mainly from the final goods and services that can be produced from it; and it generates returns measured as interest. Standing timber is capital in this economic sense regardless of whether it is a gift of nature or a product of a long period of costly management. Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  10 Forestland and timber are economic resources because they are valuable in producing other final goods and services. The demand for land and timber stems from the consumer demand for these final products, and in this sense is a “derived” demand. Forestland and the capital embodied in timber are part of a society’s total endowment of productive resources that can be used in a variety of ways to produce useful goods and services. As with other resources, the extent to which they contribute to social welfare is governed by the efficiency with which they are allocated and used. Traditionally, forest economics has been concerned with the management of forests for production of wood for industrial manufacture into building materials, pulp and paper, and so on. Forests also yield other goods and services, however, and are often managed to produce fuel wood, livestock, wildlife, recreation, and water supplies. Such benefits are often produced in combination with industrial timber production. Some of these values, especially recreational and environmental benefits, are becoming increasingly important. These increasing and overlapping demands on forest resources complicate the problem of allocating them among alternative uses and combinations of uses. Moreover, as some forest values are often not priced, they are difficult to evaluate in terms comparable with timber values, but these values are real whether or not they are priced; the absence of price indicators only complicates the problem of economic analysis. Later chapters address these issues in detail. WHY FOREST ECONOMICS? Economics deals with all kinds of productive resources, while forest economics focuses specifically on those used in forestry. The latter includes, obviously, the land and forest growth that constitute the forest itself, but it must also consider the labor, capital, and other inputs to forest operations and forest products production. Much of forest economics is con- cerned with how much of these other resources can be efficiently combined with forestland and timber in producing forest products and services. This is the subject matter of microeconomics – the half of economic science that deals with how prices and incomes are determined, how producers find the most efficient scale and form of production, how consumers behave, and so on. Forest economics builds on this basic theory as it applies to forests and land. Forest economics is therefore in large part a study in applied microeconomics. Like other special fields of applied economics, forest economics draws on the particular threads of economic theory that are relevant to the unique or especially important problems of the field. For forest economics, the theory of production, especially the theory of capital and rent, is fundamental. And, as a relatively narrow area of applied economics, it draws on broader applied fields such as the long-established specializations in land and agricultural economics and the newer branch of natural resource and environmental economics. Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  11 The special characteristics of forest resources that justify considering forest economics as a special field of study can be summarized as follows: Forests can produce a wide variety of goods and services and combinations of them, some of which are not priced in markets. This gives rise to special problems relating to the allocation of resources among uses. With the exception of some tropical and temperate species, forests typically take a long time to grow, often involving investment periods of decades. This gives rise to special problems in investment analysis, harvesting schedules, risks in carrying forest crops over long periods, and market uncertainty. It also means that forests can be altered only slowly in response to changed economic and natural conditions. Forestry usually involves very high capital and carrying costs relative to production because the slow rate of forest growth means that large forest inventories must be carried to sustain a modest harvest. As a result, the costs of forest production are often dominated by the burden of carrying land and capital over time. Forests valued for industrial timber are both productive capital and product. This fact distinguishes forests from other forms of capital and gives rise to special analytical problems in selecting the best age to harvest and in designing taxes and regulations. Governments often wield a heavy hand in forest management and utilization. Partly because forest production is a long process, partly because forests produce many goods and services that are not sold in markets, and partly because timber harvesting and intensive forest management often have adverse side effects, governments in various countries have usually had more involvement in forestry than other sectors of the economy, through public ownership, timber-harvesting and forest practices regulations, taxation, and subsidies. These features are not unique to forestry, but forestry illustrates them to a unique degree. The economic choices in forest management are constrained by the biological capacity of the resource. Those limits, and the scope for manipulating them, are the subject of the natural science of forestry, or silviculture. Silviculture is a specialized field of biology, just as forest economics is a specialized field of applied economics. Whereas silviculture is concerned with all the things that can be done to manipulate the structure and growth of forests, forest economics deals with decisions and choices within that range of possibilities, focusing attention on their social rather than biological implications. Forest economics is concerned not only with silviculture but with all aspects of forest management and forest products markets – protection, consumption, development, harvesting, and utilization of the full range of goods and services associated with forests. The natural science of forestry identifies the limits of natural systems and the range of choices available to forest managers; this range provides the framework of natural constraints within which economic analysis can help in identifying the social implications of alternative courses of action. Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  12 ECONOMIC DECISION MAKING Forest resource management ranges from the design and implementation of high policy to the execution of everyday field tasks. Broad policy objectives are determined by governments and corporate boards of directors; how particular forests are to be used is usually the decision of their private or public owners; for detailed matters, it is often foresters, superintendents, or foremen employed by the owners who make the decisions. Whatever the level, the process of decision making can be viewed as involving at least the following steps: (1) identification of goals or objectives, (2) identification of the alternative possible means of pursuing those objectives, (3) evaluation of the alternatives, (4) choice of the preferred alternative, and (5) implementation of the decision. In practice, decision making seldom follows the orderly sequence implied by this list of steps. The objectives of the parties involved are often unclear or conflicting, their motives may range from self-interest to altruism, and their time perspective may range from the immediate to the distant future. The processes of investigation and evaluation often bring out new information that causes those involved to change positions and shift alliances. As a result of this ongoing process, decision making often appears confused and disorderly, especially in matters of public policy. Nevertheless, it is helpful to the understanding of decision making to identify these separate components of the process. Identifying Goals or Objectives To make appropriate decisions, the decision maker needs a clear purpose to serve as a frame of reference for judging the desirability of one course of action compared with another. Thus, forest managers facing a decision about how to plan a harvesting program, or how much provision should be made for wildlife, or where to direct silvicultural effort must assess their alternatives in light of the objectives they are striving to achieve. There are two fundamental economic objectives: the efficiency and equity objectives discussed earlier. The relative importance of these must also be considered in decision making. Other social objectives, such as public safety, cultural awareness, and social harmony, although not normally economic objectives, have economic implications as well. Several points about objectives deserve mention. First, objectives, even at the same level of decision making, vary depending upon who is responsible for defining them. A government, for example, is likely to have different and broader objectives for the management of public forests than a corporation does in managing its private forestland. A major objective guiding the forest operations of industrial corporations is the corporations’ responsibility to shareholders to generate profits, and corporate decisions are consequently aimed largely at increasing profits. They may also be influenced by other goals, however, such as corporate growth, security of markets or resource supplies, protection of dependent manufacturing activities, or social responsibility, and firms may be prepared to compromise their current profits to advance these other goals. Similarly, small private landowners may be guided by a desire not only for profit but also for financial security, amenity, or other values that they derive from their forests. The management of public forests in democratic countries reflects Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  13 the perceived wishes of the populace, which nowadays typically puts considerable emphasis on the non-market and environmental benefits of forests, on distributional considerations, and on regional development. In short, those who make the decisions about how forests are to be managed have varying frames of reference, and hence differing objectives that lead to differing decisions. Second, the objectives of decision makers depend on the hierarchical structure of the organizations within which they work. As one moves down through the organizational structure of a government or corporation, the relevant objectives of decision makers become more narrowly defined. For example, at the highest policy-making level in a government, the goal might be to promote regional economic stability. Towards this end, the government’s forest management agency might adopt a sustainable yield objective in regulating timber harvests in each region. That objective would provide regional administrators with production objectives, the official in charge of silviculture with reforestation objectives, and the foreman of the planting crew with daily planting targets. This illustrates that at each subsidiary level of decision making the objective is different and narrower, but derives from and is consistent with the next higher objective and ultimately with the general goal of advancing regional economic stability. Third, it is important to distinguish ends from means in this context, because they are often confused. Sustained yield is an example. Sustained yield is a principle that has become so enshrined in the forestry administration of some jurisdictions that it has become institutionalized as an end in itself. It is, however, merely a formula for meeting a higher purpose, such as regional industrial stability, and unless it is clearly seen as a means to such an end, its limitations for that purpose and the implications of alternatives to it cannot be properly assessed. There are many examples of such confusion between goals and means. Concepts such as conservation and sustainable development have garnered enormous popularity as goals for natural resources management, but on closer examination both imply means to higher goals, primarily intergenerational equity. The latter (sustainable development) is defined by the World Commission on Environment and Development (or the Brundtland Commission) as “development that meets the needs of present without compromising the ability of future generations to meet their own needs.” Fourth, forest managers are often expected to pursue several objectives simultaneously. As has been suggested, a corporation might be concerned with such things as security of raw material supply or avoidance of risk as well as profit maximization, and a government may seek to provide stable regional employment or environmental benefits as well as revenues from a public forest. These various objectives are rarely perfectly complementary, and to pursue them simultaneously requires compromises among them. Economic analysis can assist in identifying and evaluating possible trade-offs, but the ultimate choice usually requires some weighting of the competing values, which are often not easily quantifiable. Similarly, the objectives of individuals or governments vary in the short term and long term, and short-term objectives may conflict with long-term goals, again calling for trade-offs and Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  14 compromise. To return to an earlier example, college students can readily attest to multiple objectives in a dynamic or inter-temporal fashion. Either by conscious choices or by default, all students have broadly defined, long-term goals. Their intermediate goals in college may be to get a good education, to find a job, to find a life partner, and to enjoy sports and a social life. In each semester or term, they may want to have good grades in various classes and learn certain skills. In everyday life, they must balance several immediate goals (or demands), such as attending classes, reading class materials, playing some sports, partying, and relaxing. Fifth, although orderly decision-making calls for explicit objectives, the objectives that forest managers are expected to pursue are sometimes vague. This is a difficulty faced most frequently in government forest agencies, where guidance about the broad purposes to be served in managing public forests is often ambiguous or even conflicting in the legislation, regulations, and administrative arrangements that articulate public policy. In such circumstances, managers are forced to infer or guess their intended objectives, and this can lead to inconsistencies and inefficiencies. Finally, it is worth emphasizing that specification of objectives is not usually the responsibility of an economist. The special expertise of the economist is not in prescribing corporate or governmental goals but in analyzing and evaluating the means of achieving them. There is, however, a normative aspect of economics in which economists incorporate their value or normative judgment about what the economy ought to be like or what particular policy actions ought to be recommended to achieve a desirable goal. In this sense, economists, along with other decision makers, can prescribe what these goals are and the ways to achieve them. Identifying Alternative Means Most corporate or public goals can be pursued in a variety of ways. At the level of high economic policy, a goal such as increased regional employment might be served by promoting industrial development, for example, which can be done in various ways through adjustments of taxes, subsidies, infrastructural improvements, or direct governmental enterprise. Forestry may be only one of several alternative means. Or, at the level of forest management planning, a goal of increasing yields might be accomplished by such varied means as improved protection, reforestation, spacing and fertilization of stands, or more complete utilization of harvested trees. Thus, once the decision maker’s objectives are identified, the next step is to identify the range of alternative strategies that can feasibly be adopted to achieve most of those objectives. This step involves assessing the technical alternatives and the inputs required to achieve a particular level of output, which in economic jargon is referred to as determining the production function. Sometimes it is also important to assess the risk or uncertainty associated with the alternative strategies. Identification of the feasible means of pursuing an objective, and of their technical production functions, is typically the responsibility of engineers, foresters, and other technical experts. For large ventures, this task sometimes becomes highly formalized in feasibility studies that Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  15 involve economists and financial analysts, while at the operational field level it typically depends on continuing subjective assessments by working supervisors. Evaluation of the Alternatives The next step is to evaluate the technical alternatives in order to provide guidance for choosing among them. It is at this stage that economic analysis is brought to bear on the decision-making process. It involves assessing the extent to which the goals of the decision maker would be advanced by particular actions, and their costs. The relationship between the value of the outputs and the cost of the inputs associated with a particular activity provides a measure of the potential net gain it can generate. Economic efficiency calls for maximizing the surplus of benefits over the cost of resources utilized, so the greater the value of output relative to the cost of inputs, the more efficient the activity is. The task of identifying the relative advantage of alternative courses of action is often complicated by incomplete information, distorted or unpriced costs and benefits, and uncertainty about future circumstances and outcomes. Notwithstanding these difficulties, economic evaluations offer a means of ranking alternative courses of action according to consistent criteria for the guidance of decision makers in selecting among the alternative strategies available to them. Economic decisions are never made with complete certainty, of course. Information about the resources and markets, and about the range of possible actions and their outcomes, is always more or less uncertain. Most decision makers are averse to risk, and so the degree of uncertainty surrounding alternative courses of action has significant influence on their choice. Attitudes towards risk taking vary considerably, however. The degree of uncertainty is therefore an important influence on decision making. It is particularly important in forestry because knowledge about the biological character of forests and their potential responses to treatments is usually limited. In addition, the long planning periods involved in forest production exacerbate the difficulty of predicting the long-term benefits and costs of actions taken today. Thus, the risks of losses from fire and other causes also contribute to the uncertainty in forestry decision making. Traditionally, economists have approached their subject in two ways. Positive economics is concerned with describing and explaining economic behavior, without judgments about its desirability; in contrast, normative economics assesses behavior in terms of given criteria or objectives, and is therefore more concerned with how economies should be organized and regulated. For our purpose, we will not follow either of these schools exclusively. We try to avoid prescribing the objectives that decision makers should adopt, or the best distribution of income; rather, our emphasis is on using economic analysis to assist those who make decisions about managing forests in identifying the most beneficial courses of action in light of their objectives. Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1  16 Choice, Implementation, and Evaluation The economist’s role in evaluating alternative courses of action is to provide guidance in decision making; it is not to make the final choice. Decision makers may, for a variety of reasons, reject the activity that appears most advantageous on purely economic grounds because of considerations of corporate strategy, political sensitivities, or other concerns not accounted for in the analysis. Nevertheless, economic analysis will help decision makers better understand the economic implications of their choices. Once a decision maker has chosen a preferred course of action, the final step of initiating and implementing the action is taken. Sometimes an additional step is added, that of review and assessment of the action taken, drawing attention to the dynamic and continuous character of decision making and the need for evaluation. The process of decision making sketched here is a central concern of management science. The growing literature in this field of study presents a variety of decision models and models of strategic behavior to help understand the relationships among decision makers, the problems of multiple and conflicting objectives, means of minimizing and coping with uncertainty, and so on. REVIEW QUESTIONS 1. Explain why economics is concerned only with the allocation of “scarce” resources. In what sense are forest resources “scarce”? Where are they not scarce? 2. Compare how management decisions are made for (a) a privately owned forest in a capitalist economy, (b) a government-owned forest in a planned socialist economy, and (c) a tribal forest in a primitive subsistence economy. 3. What are private goods? What are public goods? What are merit goods? 4. Explain how innovations in mechanized forestry can affect (a) economic efficiency in timber production, and (b) the distribution of income. 5. Describe the importance of objectives in evaluating forest management decisions. 6. If the fundamental objectives of society are either economic efficiency or equity, how would you classify the following? (In other words, which would follow the criteria of the equity objective, and which would follow the criteria of the efficiency objective?) a) A forestry firm’s immediate profits b) A forestry firm’s long-term profits c) Employment in a forested region d) Selective employment of indigenous populations e) Recreation in a forest park f) Long-term security of timber supply for a pulp mill g) Long-term preservation of biodiversity on public forestland. 7. Compare the approaches of a silviculturist and an economist in considering how best to manage a forest. What are the main concerns of each likely to be? Can their approaches be reconciled? Material taken from Zhang D & Pearse PH (2011). Forest Economics. UBC Press. For classroom purposes only. 1 FOREST ECONOMICS Economics Is the study of scarcity Economics is social science concerned with the production, distribution, and consumption of goods and services. Forest: Definition Forest is defined as an area set aside for the production of timber and other forest products, or maintained under woody vegetation for certain indirect benefits that it provides. Forest Economics: Definition Forest Economics is a discipline that studies the production, distribution, and consumption of forest products and services. Forest Economics is the branch of economics and of forestry that deals with allocating scarce resources, among competing means to satisfy human wants for forest products (Gregory 1987). Forest economics is the economics of forestry which deals with the resource management and management of forest products, conservation, and distribution. It considers the subjects individually and collectively in the form of forest economy Forestry from an economic view point Forest are economic resources Judgement about economic performance Manage forest for maximum net gain or value to the society Forest Economic Value Three types of preservation values Existence value is the value that people place on preserving forests from human disturbance for the continuing benefit of future generations; this is the value most often associated with protecting environmentally sensitive forests in their natural state as a park or some other secure form of protection. Option value is the value that forest owners or others may gain from preserving a forest in the present to maintain the option of harvesting it in the future. Bequest value is the value that people derive from bequeathing forests in their present form to future generations. Forest: Characteristics Prolonged gestation period Both capital plant and finished product Many forest products are not measured directly by existing markets An industry which is tied to nature Wood is a matter that grows on existing trees Produce indirect benefits too Forest Economics: Discussion Policy decision making Multi-functional role Public goods valuation  Traditional versus Forest Economics No. Traditional Economics Forest Economics Nascent sub-discipline of economics Less emphasis of interrelations that deals with the interrelationship 1 and interaction between forest and interaction between the forest and economy and economic activities. Deals with private goods that are Deals with both private and public 2 bought and sold in the market goods Does not take into account 3 Takes into account the externalities externalities Time-related decisions do not Time-related decisions receive much 4 receive much attention attention Limited capacity of the forest is Limited capacity of the forest is 5 not considered explicitly considered EÁˉ ¸ š 8ÆÁ∙ Á‡ Œ Æ̧: Nature and Scope Nature: Quality or Character Science Art Both Normative- Positive Forest Economics: As a science Systematic body of knowledge Cause and effect relationship Capable of measurement It’s own methodological apparatus It’s ability to forecast Forest Economics: As an art An Art is a system of rules for the attainment of a given end. Art To do Science Practice of How to do? knowledge Forest Economics: Scope Allotment of forestland Selection of suitable tree crop Employment potential Utilization of forest products Stress on plantation activity Value addition to forest products Economic use of forestry products Determination of rotation Forest Economics: Scope Formulation of export policy Policy for basis of distribution To analyze people’s participation Protection of endangered species Forecasting of future requirements PRACTICAL IMPORTANCE 1. Forest economics addresses the economic problems involving in buying, selling and management of forest land used for water resources, wildlife and some other produce. 2. Forest economics also deals with economic problems of growing, protecting, harvesting and marketing of forest products. 3. Forest economics is concerned about forest land related human and industrial resources to satisfy human wants. PRACTICAL IMPORTANCE 4. Forest economics identifies and analyzes the cost and return from various forest resources. On the basis of these information owners of the forest estimates the return from their crops and make the decision whether to harvest their trees or continue growing the field. 5. Forest economics uses different economic models to analyze the realistic view of supply and demand situation. Economic models are usually used to explain or predict the situation. PRACTICAL IMPORTANCE 6. Forest economics help the farmer to make the decision about harvesting, transportation, and marketing of wood or wood products. Because the effect of most forest management decision becomes evident only after the considerable lapse of time, guides for evaluating the probable results of such decisions are extremely useful. 7. Forest economics is concerned with applying the tools of economics analyzing the problems of forest production, demand, and supply. To a forest economist, the demand for forest product is the functional relationship between the quantities of a commodity or services that buyer willing and able to purchase at different prices during a specified time. Factors that distinguish forest economics as a separate applied field of economics. Diversity of forest landowners – public and private, industrial and non- industrial) - leads to a diversity of preferences, expectations, and constraints. Long time frames involved in forest production give rise to the classical problem of choosing optimal rotation lengths, capital budgeting, and modern financial analysis. Forests jointly produce multiple outputs, some extracted and some valued in situ, some traded in the market and some not, and some accruing to forest owners and some to the public. Those not traded in the market, whether consumed by landowners or by the public, have no market price signals to predict behavior or guide allocation. Immobility of forests lends greater importance to the issue of market power and to travel costs as necessary inputs to forest use. Economic problems in forestry determination of the amount of consumption, importation and exportation of timber and other forest products determination of the supply of forest products for the present and future wants renewal, preservation and conservation of the forest influence of forest on the climate, soil erosion, floods etc.  The forest problem is a problem of divestment, which means the solution calculates the optimal time to consolidate and sell the entire stock and begin the next rotation The analogy of a forest rotation is that of a conventional cropwhich does not get harvested every season; That is, the growth cycle of a forest resource is so long that resource owners get really impatient and discounting/ dynamic analysis is important. How is the Forestry Problem Different from a Fishery? 1. Forest Solutions Determine “When” Rather than “How Much” 2. Growth Occurs over Long Time Periods and Can be Measured 3. The Forest Problem Solves For the Optimal Time to Harvest Entire Stock - the solution gives the optimal length of each rotation of stock 4. Property Rights are Secure (No Open Access Problems) ??? Factors affecting timber production Peculiarities of timber production o immobility of standing timber o long period of production o dual nature of standing timber – factory and product at the same time o high ratio of inventory to annual growth o one way flexibility of production and marketing o aggregative nature of the forest o presence of externalities Factors affecting timber production Ownership of forest land Interest - price paid for the use money or capital Credit availability Taxes  FMgt 147n Forest Economics & Valuation DENNIS P. PEQUE, PhD, RPF, EnP Course Professor Introduction to Course and Economics Economics is the study of the ALLOCATION of SCARCE resources to meet UNLIMITED human wants. a. Microeconomics - is concerned with decision-making by individual economic agents such as firms and consumers. b. Macroeconomics - is concerned with the aggregate performance of the entire economic system. c. Empirical economics - relies upon facts to present a description of economic activity. d. Economic theory - relies upon principles to analyze behavior of economic agents. e. Inductive logic - creates principles from observation. f. Deductive logic - hypothesis is formulated and tested. Usefulness of economics Economics provides an objective mode of analysis, with rigorous models that are predictive of human behavior. a. Scientific approach b. Rational choice Assumptions in Economics Economic models of human behavior are built upon assumptions; or simplifications that permit rigorous analysis of real world events, without irrelevant complications. a. model building - models are abstractions from reality - the best model is the one that best describes reality and is the simplest. b. simplifications: ceteris paribus - means all other things equal. There are problems with abstractions, based on assumptions. Too often, the models built are inconsistent with observed reality - therefore they are faulty and require modification. When a model is so complex that it cannot be easily communicated or its implications easily understood - it is less useful. Goals and their Relations a. POSITIVE economics is concerned with what is; b. NORMATIVE economics is concerned with what should be. Economic goals are value statements, hence normative c. Economics is not value free, there are judgments made concerning what is important: 1. Individual utility maximization versus social betterment 2. Efficiency versus fairness 3. More is preferred to less Goals and their Relations d. Most societies have one or more of the following goals, depending on historical context, public opinion, and socially accepted values : 1. Economic efficiency, 2. Economic growth, 3. Economic freedom, 4. Economic security, 5. Equitable distribution of income, 6. Full employment, 7. Price level stability, and 8. Reasonable balance of trade. Goals are subject to: a. interpretation - precise meanings and measurements will often become the subject of different points of view, often caused by politics. b. goals that are complementary are consistent and can often be accomplished together. c. conflicting - where one goal precludes or is inconsistent with another. d. priorities - rank ordering from most important to least important; again involving value judgments. Economic Problems The economizing problem involves the allocation of resources among competing wants. There is an economizing problem because there are: a. unlimited wants b. limited resources Economic Problems Resources and factor payments: a. land - includes space (i.e., location), natural resources, and what is commonly thought of as land. land is paid rent b. capital - are the physical assets used in production - i.e., plant and equipment. capital is paid interest c. labor - is the skills, abilities, knowledge (called human capital) and the effort exerted by people in production. labor is paid wages d. entrepreneurial talent - (risk taker) the economic agent who creates the enterprise. entrepreneurial talent is paid profits Economic Problems Full employment includes the natural rate of unemployment and down time for normal maintenance (both capital & labor). However, full production or 100% capacity utilization cannot be maintained for a prolonged period without labor and capital breaking-down: underemployment - utilization of a resource in a manner, which is less than what is consistent with full employment - using a Forester as a Forest Ranger. Economic Efficiency Consists of the following three components: a. allocative efficiency - is measured using a concept known as Pareto Superiority (or Optimality) 1. Pareto Optimal - is that allocation where no person could be made better off without inflicting harm on another. 2. Pareto Superior - is that allocation where the benefit received by one person is more than the harm inflicted on another. [cost - benefit approach] b. technical efficiency - for a given level of output, you minimize cost or (alternatively) for a given level of cost you maximize output. c. full employment - for a system to be economically efficient then full employment is also required. Economic Problems Allocations of resources imply that decisions must be made, which in turn involves choice. Every choice is costly; there is always the lost alternative -- the opportunity cost: a. opportunity cost - the next best alternative that must be foregone as a result of a particular decision. Economic Problems The production possibilities curve is a simple model that can be used to show choices: b. assumptions necessary to represent production possibilities in a simple production possibilities curve model: 1. efficiency 2. fixed resources 3. fixed technology 4. two products Economic systems Rarely exist in a pure form. The following classification of systems is based on the dominant characteristics of those systems: a. pure capitalism - private ownership of productive capacity, very limited government, and motivated by self-interest. 1. laissez faire - government hands-off; markets relied-upon to perform allocations. 2. costs of freedom - poverty, inequity and several social ills are associated with the lack of protection afforded by government. Economic systems b. command - government makes the decisions - with force of law (and sometimes martial force) - Often associated with dictatorships c. traditional - based on social mores or ethics or other non-market, non-legislative bases - Christmas gift giving is tradition d. socialism - maximizes individual welfare based on perceived needs, not contributions; generally concerned more with perceived equity than efficiency. Economic systems d. communism - everyone shares equally in the output of society (according to their needs), generally no private holdings of productive resources 1. The former Soviet Union espoused communism, but also was mostly command 2. Utopian movement in the U.S. – perfect society Economic systems f. mixed system - contains elements of more than one system - U.S. economy is a mixed system (capitalism, command, and socialism are the major elements, with some communism and tradition) - All of the high income, industrialized economies are mixed economies - Even with mixed systems there are substantial variations in the amounts of socialism, capitalism, tradition, and command exist in each example. Basics of Supply and Demand 1. A market is nothing more or less than the locus of exchange; it is not necessarily a place, but simply buyers and sellers coming together for transactions. 2. The law of demand states that as price increases (decreases) consumers will purchase less (more) of the specific commodity. Basics of Supply and Demand The demand schedule (demand curve) reflects the law of demand. It is a downward sloping function and is a schedule of the quantity demanded at each and every price. As price falls from P1 to P2 the quantity demanded increases from Q1 to Q2. This is a negative relation between price and quantity, hence the negative slope of the demand schedule; as predicted by the law of demand. Basics of Supply and Demand a. Utility (use, pleasure, jollies) from the consumption of commodities. b. The change in utility derived from the consumption of one more unit of a commodity is called marginal utility. c. Diminishing marginal utility is the fact that at some point further consumption of a commodity adds smaller and smaller increments to the total utility received from the consumption of that commodity. Basics of Supply and Demand b. The income effect is the fact that as a person's income increases (or the price of item goes down [which effectively increases command over goods] more of everything will be demanded. c. The substitution effect is the fact that as the price of a commodity increases, consumers will buy less of it and more of other commodities. Demand Curve a. Price and quantity - again the demand curve shows the negative relation between price and quantity. b. Individual versus market demand - a market demand curve is simply an aggregation of all individual demand curves for a particular commodity. c. Nonprice determinants of demand; and a shift to the left (right) of the demand curve is called a decrease (increase) in demand. Demand Curve The nonprice determinants of demand are: 1. tastes and preferences of consumers, 2. the number of consumers, 3. the money incomes of consumers, 4. the prices of related goods, and 5. consumers' expectations concerning future availability or prices of the commodity. Demand Curve Changes in demand versus in quantity demanded. An increase in demand is shown in the first panel, notice that at each price there is a greater quantity demanded along D2 (the dotted line) than was demanded with D1 (the solid line). The second panel shows a decrease in demand, notice that there is a lower quantity demanded at each price along D2 (the dotted line) than was demanded with D1 (the solid line). Demand Curve Changes in quantity demanded Movement along a demand curve is called a change in the quantity demanded. Changes in quantities demanded are caused by changes in price. When price decreases from P1 to P2, the quantity demanded increases from Q1 to Q2; when price increases from P2 to P1 the quantity demanded decreases from Q2 to Q1. Law of Supply The law of supply is that producers will supply more the higher the price of the commodity. a. Supply schedule - are the quantities supplied at each and every price. Law of Supply Supply curve - is nothing more than a schedule of the quantities at each and every price. a. There is a positive relation between price and quantity on a supply curve. b. Changes in one or more of the nonprice determinants of supply cause the supply curve to shift. A shift to the left of the supply curve is called a decrease in supply; a shift to the right is called an increase in supply. Law of Supply The nonprice determinants of supply are: 1. resource prices, 2. technology, 3. taxes and subsidies, 4. prices of other goods, 5. expectations concerning future prices, and 6. the number of sellers. Law of Supply A decrease in supply is shown in the first panel, notice that there is a lower quantity supplied at each price with S2 (dotted line) than with S1 (solid line). The second panel shows an increase in supply, notice that there is a larger quantity supplied at each price with S2 (dotted line) than with S1 (solid line). Law of Supply Changes in quantity supplied Changes in price cause changes in quantity supplied, an increase in price from P2 to P1 causes an increase in the quantity supplied from Q2 to Q1; a decrease in price from P1 to P2 causes a decrease in the quantity supplied from Q1 to Q2. Market equilibrium Occurs where supply equals demand (supply curve intersects demand curve). An equilibrium implies that there is no force that will cause further changes in price, hence quantity exchanged in the market. This is analogous to a cherry rolling down the side of a glass; the cherry falls due to gravity and rolls past the bottom because of momentum, and continues rolling back and forth past the bottom until all of its' energy is expended and it comes to rest at the bottom - this is equilibrium. Market equilibrium The graphical analysis on the right portrays a market in equilibrium. Where the supply and demand curves intersect, equilibrium price is determined (Pe) and equilibrium quantity is determined (Qe). Market equilibrium The graph of a market in equilibrium can also be expressed using a series of equations. Both the demand and supply curve can be expressed as equations. Demand Curve is Qd = 22 - P Supply Curve is Qs = 10 + P The equilibrium condition is Qd = Qs Therefore: 22 - P = 10 + P Adding P to both sides of the equation yields: 22 = 10 + 2P Subtracting 10 from both sides of the equation yields: 12 = 2P or P = 6 To find the equilibrium quantity, we plug 6 (for P) into either the supply or the demand curve and get: 22 - 6 = 16 (Demand side) 10 + 6 = 16 (Supply side) Changes in supply and demand Changes in supply and demand in a market result in new equilibria. The following graphs demonstrate what happens in a market when there are changes in nonprice determinants of supply and demand. Changes in demand Movement of the demand curve from D1 to D2 is a decrease in demand. Such decreases are caused by a change in a nonprice determinant of demand (for example, the number of consumers in the market declined or the price of a substitute declined). With a decrease in demand there is a shift of the demand curve to the left along the supply curve, therefore both equilibrium price and quantity decline. If we move from D2 to D1 that is called an increase in demand, possibly due to an increase in the price of a substitute good or an increase in the number of consumers in the market. When demand increases both equilibrium price and quantity increase as a result. Changes in supply Movement of the supply curve from S1 to S2 is an increase in supply. Such increases are caused by a change in a nonprice determinant (for example, the number of suppliers in the market increased or the cost of capital decreased). With an increase in supply there is a shift of the supply curve to the right along the demand curve, therefore equilibrium price and quantity move in opposite directions (price decreases, quantity increases). If we move from S2 to S1 that is called a decrease in supply, possibly due to an increase in the price of a productive resource (capital) or the number of suppliers decreased. When supply decreases, equilibrium price increases and the quantity decreases as a result. That is the result of the supply curve moving up along the negatively sloped demand curve (which remains unchanged). Changes in demand supply Notice that the quantity remains the same in both graphs. Therefore, the change in the equilibrium quantity is indeterminant and its direction and size depends on the relative strength of the changes between supply and demand. In both cases, the equilibrium price changes. In the first case where demand increases, but supply decreases the equilibrium price increases. In the second panel where demand decreases and supply increases, the equilibrium price decreases. Changes in demand supply In the event that demand and supply both increase then price remains the same (is indeterminant) and quantity increases, and if both decrease then price is indeterminant and quantity decreases. The graphs show that price remains the same (is indeterminant) but when supply and demand both increase quantity increases to Q2. When both supply and demand decrease quantity decreases to Q2. Shortages and surpluses Occur because of effective government intervention in the market. Shortage is caused by an effective price ceiling (the maximum price you can charge for the product). Consider the diagram on the right that Shortage demonstrates the effect of a price ceiling in an otherwise purely competitive industry. Shortages For a price ceiling to be effective it must be imposed below the competitive equilibrium price. Note that the Qs is below the Qd, which means that there is an excess demand for this commodity that is not being satisfied Shortage by suppliers at this artificially low price. The distance between Qs and Qd is called a shortage. Surpluses Surplus is caused by an effective price floor (i.e., the minimum you can charge). For a price floor to be effective, it must be above the competitive equilibrium price. Notice that at the floor price Qd is less than Qs, the distance between Qd and Qs is the amount of the surplus. Minimum wages are the best-known examples of price floors. Supply and Demand is rudimentary Does not exist in the real world. In most respects the supply and demand model is the beginning point for understanding markets. Monopoly, monopolistic competition and oligopoly are, in some important respects, refinements from the purely competitive market. Therefore, the basic supply and demand model may accurately be thought of as the beginning point from which we will explore more realistic market structures. Supply & Demand: Elasticities Price Elasticity of Demand is how economists measure the responsiveness of quantities demanded to changes in prices. The elasticity coefficient is calculated using the midpoints formula presented below: Supply & Demand: Elasticities Elastic demand means that the quantities demanded respond more than proportionately to changes in price; with elastic demand the coefficient is more than one. Inelastic demand means that the quantities demanded respond less than proportionately to changes in price; with inelastic demand the coefficient is less than one. Unit elastic demand means that the quantity demanded respond proportionately to change in prices; with unit elastic demand the coefficient is exactly one. Perfectly Elastic and Perfectly Inelastic Demand Curves Notice that the perfectly elastic demand curve is horizontal, (add one more horizontal line at the top of the price axis and it will look like an E) and the inelastic demand curve is vertical (looks like an I). Elasticity changes along the demand curve, however slope does not. Elasticity is concerned with changes along the curve rather than the shape or position of the curve. Demand Curve and Total Revenue Demand Curve and Total Revenue (total revenue = P x Q) Curve In examining the graph on the rigth, notice that as total revenue is increasing, demand is elastic. When the total revenue curve flattens-out at the top then demand becomes unit elastic, and when total revenue falls demand is inelastic. Total Revenue Test It uses the relation between the total revenue curve and the demand curve to determine elasticity. The total revenue test is simply the inspection of the data to see what happens to total revenue. If the change in total revenue (marginal revenue) is positive then demand is price elastic, if the change in total revenue is negative the demand is price inelastic. If the marginal revenue is exactly zero then demand is unit elastic. Determinants of the price elasticity of demand The determinants of the price elasticity of demand will determine how responsive the quantity demanded is to changes in price. These determinants are: a. substitutability b. proportion of income c. luxuries versus necessities d. time Price Elasticity of Supply Price Elasticity of Supply is determined by the following time frames. The more time a producer has to adjust output the more elastic is supply. a. market period b. short run c. long run Cross elasticity of demand Measures the responsiveness of the quantity demanded of one product to changes in the price of another product. For example, the quantity demanded of Coca-Cola to changes in the price of Pepsi. Income elasticity of demand Measures the responsiveness of the quantity demanded of a commodity to changes in consumers' incomes. Thank You!!!  DENNIS P. PEQUE, PhD GOODS AND SERVICES GOODS In economics, goods are items that satisfy human wants and provide utility, for example, to a consumer making a purchase of a satisfying product. Goods are transferable, and services, are not. Kinds of Goods Economic good if it is useful to people but scarce in relation to its demand so that human effort is required to obtain it. Free goods such as air, are naturally in abundant supply and need no conscious effort to obtain them. Private goods are things owned by people, such as TVs, living room furniture, cellular phones, almost anything owned or used on a daily basis that is not food-related. Consumer good or "final good" is any item that is ultimately consumed, rather than used in the production of another good. A microwave oven or a bicycle that is sold to a consumer is a final good or consumer good, but the components that are sold to be used in those goods are intermediate goods. Primary vs secondary wood products Goods can be classified by exclusivity and competitiveness F P A R C O T D O U R C S T I O O F N Factors of production are the inputs needed for creating a good or service, and the factors of production include land, labor, entrepreneurship, and capital. Those who control the factors of production often enjoy the greatest wealth in a society. In capitalism, the factors of production are most often controlled by business owners and investors. In socialist systems, the government (or community) often exerts greater control over the factors of production. The state of technological progress can influence the total factors of production and account for any efficiencies not related to the four typical factors. Land Has a broad definition as a factor of production and can take on various forms, from agricultural land to commercial real estate to the resources available from a particular piece of land. Natural resources, such as oil and gold, can be extracted and refined for human consumption from the land. Cultivation of crops on land by farmers increases its value and utility. Its importance can diminish or increase based on industry. For example, a technology company can easily begin operations with zero investment in land. On the other hand, land is the most significant investment for a real estate venture. Labor Refers to the effort expended by an individual to bring a product or service to the market. It can take on various forms. For example, the construction worker at a hotel site is part of labor, as is the waiter who serves guests or the receptionist who enrolls them into the hotel. Human capital BPO industry Capital Typically refers to money. However, money is not a factor of production because it is not directly involved in producing a good or service. Instead, it facilitates the processes used in production by enabling entrepreneurs and company owners to purchase capital goods or land or to pay wages. Capital is the primary driver of value. Capital refers to the purchase of goods made with money in production. For example, a tractor purchased for farming is capital. Along the same lines, desks and chairs used in an office are also capital. Entrepreneurship is the secret sauce that combines all the other factors of production into a product or service for the consumer market. Evolution of social media Ownership of the factors of production Are All Factors of Production Equally Important? Some factors of production might be more important than others. For example, a software company that relies primarily on the labor of skilled software engineers might see labor as its most valuable factor of production. Meanwhile, a company that makes its money from building and renting out office space might see land and capital as its most valuable factors. As the demands of a business change over time, the relative importance of the factors of production will also change accordingly. Summary Land refers to physical land, such as the acres used for a farm or the city block on which a building is constructed. Labor refers to all wage-earning activities, such as the work of professionals, retail workers, and so on. Capital refers to the cash, equipment, and other assets needed to start or grow a business. Entrepreneurship refers to the initiatives taken by entrepreneurs, who typically begin as the first workers in their firms and then gradually employ other factors of production to grow their businesses. C G O O N O S D U S M E R Consumer goods are products bought for consumption by the average consumer. Also called final goods, consumer goods are the end result of production and manufacturing. Clothing, food products, and dishwashers are examples of common consumer goods. Types of Consumer Goods Durable goods are consumer goods that have a life span of over three years and are used repeatedly over time. Bicycles and refrigerators are considered durable goods. Nondurable goods are consumed in less than three years, are commonly used one time and include packaged food and drinks or laundry detergent. Service goods include items like auto repairs and haircuts that are intangible consumer goods. Types of Consumer Goods Convenience goods are those that are regularly consumed and are readily available for purchase. They are often nondurable goods and low-priced items sold by wholesalers and retailers. Examples of convenience goods include milk and tobacco products. Shopping goods are those items bought less frequently, are durable, and are commonly more expensive than convenience goods. Examples of shopping goods include furniture and televisions. Types of Consumer Goods Specialty consumer goods are rare and often considered luxury purchases. They are often marketed by brand or geared to a niche market. Sports cars and fine art are examples of specialty consumer goods. Unsought consumer goods are readily available but not often sought by the consumer. Although they may be necessary purchases, they require marketing to consumers to nudge a purchase. Examples of unsought consumer goods include life insurance and pre-paid funeral expenses. E S C Y O S N T O E M M I C Economic system a means by which societies or governments organize and distribute available resources, services, and goods across a geographic region or country. regulate the factors of production, including land, capital, labor and physical resources. encompasses many institutions, agencies, entities, decision-making processes, and patterns of consumption that comprise the economic structure of a given community. Types of Economic System each has its own distinguishing characteristics but all share some basic features Traditional economies Command economies Mixed economies Market economies.  Traditional economic system is based on goods, services, and work, all of which follow certain established trends. It relies a lot on people, and there is very little division of labor or specialization. is commonly found in rural settings in second and third world nations, where economic activities are predominantly farming or other traditional income-generating activities. lacks the potential to generate a surplus. Nevertheless, precisely because of its primitive nature, the traditional economic system is highly sustainable. In addition, due to its small output, there is very little wastage compared to the other three systems.  Consumer surplus occurs when the consumer’s willingness to pay for a product is greater than its market price. Producer surplus is the total amount that a producer benefits from producing and selling a quantity of a good at the market price. The total revenue that a producer receives from selling their goods minus the marginal cost of production equals the producer surplus. PS + CS = the total economic benefit to everyone in the market from participating in production and trade of the good. Command economic system there is a dominant centralized authority – usually the government – that controls a significant portion of the economic structure. is common in communist societies since production decisions are the preserve of the government. Ideally, centralized control covers valuable resources such as gold or oil. The people regulate other less important sectors of the economy, such as agriculture. vulnerable to economic crises or emergencies, as they cannot quickly adjust to changing conditions since control is exercise by central government. Market economic systems are based on the concept of free markets wherein the government exercises little control over resources, and it does not interfere with important segments of the economy. regulation comes from the people and the relationship between supply and demand. is mostly theoretical as pure market system does not really exist due to laws enacted by governments that regulate fair trade and monopolies. From a theoretical point of view, a market economy facilitates substantial growth. A market economy’s greatest downside is that it allows private entities to amass a lot of economic power, particularly those who own resources of great value. The distribution of resources is not equitable because those who succeed economically control most of them. Mixed systems Combine the characteristics of the market and command economic systems. Many countries in the developed western hemisphere follow a mixed system. Most industries are private, while the rest, composed primarily of public services, are under the control of the government. Supposedly, a mixed system combines the best features of market and command systems. Practically speaking, mixed economies face the challenge of finding the right balance between free markets and government control. Governments tend to exert much more control than is necessary. Summary Economic systems are grouped into traditional, command, market, and mixed systems. Traditional systems focus on the basics of goods, services, and work, and they are influenced by traditions and beliefs. A centralized authority influences command systems. A market system is under the control of forces of demand and supply. Mixed economies are a combination of command and market systems. CIRCULAR FLOW MODEL The circular flow model demonstrates how money moves through society. Money flows from producers to workers as wages and flows back to producers as payment for products. In short, an economy is an endless circular flow of money. The models can be made more complex to include additions to the money supply, like exports, and leakages from the money supply, like imports. The circular flow model Resource and Product flow model