1. Supply as a Marginal Cost

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As Nautiyal (1988, p. 4) stated:

"a given economic theory remains the same whether dealing with bread, furniture, automobiles, timber, recreation or wildlife."

Forest economics is an applied field of economics dealing with the economic problems involved in buying, owning, selling, taxing and managing forest land, whether used for the production of water, wildlife, wood or any other product (Gregory, 1972). Gregory (1987) defined forest economics "as the branch of forestry, and of economics, that deals with allocating scarce resources among competing means to satisfy human wants for forest products."


We will start with a few fundamental concepts and principles of economics illustrated within simplified forest sector cases. As the building blocks for (forest) economics we must first review the basic logic of the following general economic concepts: supply, demand, marginal and total willingness to pay (MWTP & TWTP), marginal and total cost (MC, TC), the competitive free market and market equilibrium.   

Supply as marginal cost: A case study

Here is a simplified hypothetical example to derive the supply curve from production costs. For simplicity, let us assume that we have a nursery company producing only one type of seedling - two-year old Norwegian Spruce (Picea abies) seedlings to be used in forest plantations.

To get the seedlings it is necessary for the nursery to use seeds, fertilizers, labor and land among other things as inputs (Table E1). For example, the production of 10,000 seedlings requires labor costing € 932. This labor cost can be estimated using market wage rates. This is the value that labor would have produced in its next best production opportunity (i.e., the opportunity cost of labor input). The price of a good (in general) is an indicator of the scarcity of inputs used to produce it. The more severe the scarcity, the higher the price.

Table E1: Revenues and costs for a nursery company producing 2-year old Norwegian Spruce seedlings

Items
Value
Revenue from seedlings produced
€ 2000 per 10000 seedlings
Variable costs
€ 1100 per 10000 seedlings
Material (seeds, fertilizers,....)
€ 85 per 10000 seedlings
Variable labor costs
€ 932 per 10000 seedlings
Other
€ 83 per 10000 seedlings
Fixed costs (interest on dept., depreciation,....)
€ 4300 per ha per year
Normal return to capital (profit target)
€ 1100 per ha per year

In the short run1, the land area is assumed to be fixed at one hectare. A company is one of many small producers in a large market. Hence, the company faces a horizontal demand curve for seedlings and it receives the same price, of €2,000 per 10,000 seedlings, no matter how many seedlings it sells.2

In order to maximize annual profit, the owner has to find the optimum seedling output. Increasing output necessitates an increase in the use of variable inputs, and returns from the added input are diminished since the land area is held constant (in the short run).3

Marginal revenues (MR) and marginal costs (MC) are the differences in total revenues and total costs for each output increase of 10,000 seedlings. In other words, they are the added total revenue and the total cost from the last 10,000 seedlings.4

In Table E2 we can see that the optimum annual output is 70,000 seedlings per hectare. Then the excess profit (i.e., profit above normal profit) is maximized. The nursery increases production until the marginal cost exceeds the marginal revenue (i.e., the price) (Figure E1). Note that MR exactly equals MC at a point between 70,000 and 80,000 seedlings.

Table E2: Revenues and costs for one hectare at each output level
Output 10000 seedlings
Total revenue
Marginal revenue
Variable cost
Total cost
Marginal cost
Excess profit
0
0
0
0
5400
0
-5400
1
2000
2000
1100
6500
1100
-4500
2
4000
2000
1900
7300
800
-3500
3
6000
2000 2700
8100
800
-2100
4
8000
2000 3700
9100
1000
-1100
5
10000
2000 4900
10300
1200
-300
6
12000
2000 6400
11800
1500
+200
7
14000
2000 8300
13700
1900
+300 (MAX)
8
16000
2000 10600
16000
2300
0
9
18000
2000 13500
18900
2900
-900
10
20000
2000 17100
22500
3600
-2500


This is the first example showing the importance of marginal or incremental analysis in (forest) economics. It illustrates the necessary condition for profit maximization where an increase in production results when marginal cost equals marginal revenue (i.e. output price under perfect competition).5

In Figure E1, the marginal cost curve shows the optimal output levels that will be supplied at different output prices. Thus the MC curve essentially defines the firm's supply curve. More precisely, the company's supply curve in the long term is only the portion of the marginal cost curve above the minimum average costs (total costs divided by units of output). If the output price falls below the minimum average cost, the firm is unlikely to stay in business over the long term. The supply curve is upward sloping, thus the higher the price, the more a firm produces.



Figure E1: Marginal costs (MC) and revenues (P) per 10,000 seedlings

An industry supply curve is the horizontal sum of the individual firms' supply curves (Figure E2). If, for example, the price of seedlings were 1,500 € per 10,000 seedlings, Firm I would produce 60,000 seedlings and Firm II would produce 70,000 seedlings. The output for the "industry" would then be 130,000 seedlings. But, if the price were higher, for example, 2,300€ per 10,000 seedlings, the industry supply would be 170,000 seedlings where 80,000 seedlings would be produced by Firm I and 90,000 seedlings by Firm II.



Figure E2: Horizontal sum of two nurseries' supply curves gives the two-firm industry supply curve

1. The amount of at least one input is fixed, and consequently some costs are fixed, i.e. constant, regardless of output. In the long run, all inputs (and all costs) are variable. For example, the capacity (size) of the firm can be increased by investments.

2. In a perfectly competitive market producers are called "price takers." This means that if a firm increases its price, forest owners will buy seedlings elsewhere and the owner is called the "profit maximizer" who tries to maximize net revenue, (i.e. the excess of revenues over costs per year).

3. Optimizing input use is excluded here.

4. Marginal cost does not equal € 1,100 per 10,000 seedlings because of diminishing returns to added input after 30,000 seedlings.

5. It is important to keep in mind that this condition was derived from the optimization behavior and in this case the company aimed to maximize profit.

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