Saturday, December 15, 2007

Privatized Deforestation and Profits

Let’s start from the very beginning. One of the commonly accepted statements that were explicitly made throughout the semester was that privatization of forests would eliminate inefficiency of forest logging. In this post I examine the incentives of forest loggers and question the validity of the accepted class’s theorem.

Assumptions. I hereby assume the model of a non-corporate private sector entity (a non-public firm that is either a sole proprietorship or a partnership) that generates positive profits in the forest logging industry that is not a monopoly market structure. Under a logical presumption that the current owner of the business is not going to live forever, the owner will most likely try to sell the business to a younger individual at some point. I also presume that the current owner will try to maximize the price for which he will sell the property in the course of price negotiations with the buyer.

I emphasize that this is a private company because the mechanism for property appraisal differs between the privately held companies and publicly held companies. Here is how it works.

First, a company is selling goods at some price(s) making total revenue. If we were to subtract the cost of revenue (which is the cost of goods sold, do not confuse with total cost!) from total revenue, we would get the firm’s gross profit. After subtracting operating expenses (which are a sum of fixed and variable costs) from gross profit, we then derive earnings before interest and taxes (EBIT). Now, if it were a privately owned company, its sale value would be determined by multiplying EBIT by a number between 8 and 10 years. That way, it would estimate the forgone future income for the following period between 8 and 10 years.

If the current owner is interested in maximizing the price he can receive from the sell of the property, he will most likely be interested in maximizing EBIT during the last year before the sale occurs. Doing so means maximizing total revenue. Given that a logging industry is not a monopoly implies a single firm’s somewhat limited control over price of homogenous goods (after all, it is wood we are talking about). It also means that the firm will try to maximize its total revenue by increasing the quantity supplied, which means it will cut down even more forest. (I realize you might think that a single year’s increase in logging each time the business gets resold may not mean much but I strongly urge you to consider the power of aggregates given the number of logging business out there as well as the frequency of ownership changes). As you can see, evaluating the value of a privately held logging company based on EBIT may not be the best environmental choice. Instead, a party interested in purchasing the forest for the purposes of logging may suggest a few different approaches for calculating a mutually agreed upon price. Such approach will result in a slower rate of deforestation, lower price that the business would be sold for, and it would even contribute a miniscule part to inflation reduction.

Another way to calculate the value of the business is to calculate the present value of an annuity of the business under consideration (with an embedded assumption of equal payments in the future). Such calculation would presume that the amount of total revenue that the business would most likely generate would remain fixed over a number of years. Quite naturally, it implies that real (inflation-adjusted) annual incomes from that business diminish annually. Even though theoretically possible, it is empirically highly unlikely. Instead, I would advise using the sum of present values of an asset discounted with appropriate interest rate. Such approach eliminates the incentives to drastically increase the logging’ output throughout the year preceding the buyout and as a result leaves more trees for you, me, and the tree huggers. As you can see, it is not the privatization of forests that will be efficient but the mechanism of evaluating logging businesses that will influence efficiency.

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