The effect of timber export restrictions on the domestic market for timber

The housing crisis is causing the government to search frantically for solutions. As the New Zealand Herald reported last week:

The Government was warned its efforts to tackle New Zealand's housing affordability issues could be hampered by wood shortages.

The issue has become so significant, Building and Construction Minister Poto Williams is considering limiting timber exports to ensure there is enough in the country.

What happens if the government limits timber exports, by implementing an export quota? Before we can answer that question, we need to consider the effect of exports on the domestic market, without any restrictions on exports. That situation is shown in the diagram below. New Zealand is an exporting country, which means that New Zealand has a comparative advantage producing timber. That means that New Zealand can produce timber at a lower opportunity cost than other countries. On a supply-and-demand diagram like the one below, it means that the domestic market equilibrium price of timber (PD) would be below the price of timber on the world market (PW). Because the domestic price is lower than the world price, if New Zealand is open to trade there are opportunities for traders to buy timber in the domestic market (at the price PD), and sell it on the world market (at the price PW) and make a profit (or maybe the suppliers themselves sell directly to the world market for the price PW). In other words, there are incentives to export timber. The domestic consumers would end up having to pay the price PW for timber as well, since they would be competing with the world price (and who would sell at the lower price PD when they could sell on the world market for PW instead?). At this higher price, the domestic consumers choose to purchase Qd0 timber, while the domestic suppliers sell Qs0 timber (assuming that the world market could absorb any quantity of timber that was produced). The difference (Qs0 - Qd0) is the quantity of timber that is exported. Essentially the demand curve with exports follows the red line in the diagram.

In terms of economic welfare, if there was no international trade in timber, the market would operate at the domestic equilibrium, with price PD and quantity Q0. Consumer surplus (the gains to domestic timber consumers) would be the area AEPD, the producer surplus (the gains to domestic timber producers) would be the area PDEF, and total welfare (the sum of consumer surplus and producer surplus, or the gains to society overall) would be the area AEF. With trade, the consumer surplus decreases to ABPW, the producer surplus increases to PWCF, and total welfare increases to ABCF. Since total welfare is larger (by the area BCE), this represents the gains from trade.

Now consider what would happen if there is an export quota limiting the quantity of timber exports below (Qs0 - Qd0). This is shown in the diagram below. Let's say that the quantity of exports is reduced to the amount between B and G on the diagram (about half the amount of exports that were previously occurring). Now consider what happens to the demand curve (including exports). The upper part represents the domestic consumers with high willingness-to-pay for timber. Then there is a limited quantity of exports that are allowed under the export quota, at the world price PW. After that, there are still profit opportunities for domestic suppliers (that is, there are still some domestic consumers who are willing to pay more than what it costs the suppliers to produce timber). So, the demand curve (including the export quota) pivots at the point G, and follows a parallel path to the original demand curve (i.e. the demand curve including exports follows the red line in the diagram). The domestic price is the price where supply is equal to demand (P1). The domestic consumers choose to purchase Qd1 timber at the price P1, while the domestic suppliers sell Qs1 timber at that price. The difference (Qs1 - Qd1) is the quantity of exports. Notice that the price of timber that timber consumers pay has fallen, and more timber is purchased domestically - we'll come back to those points shortly.

Now consider the areas of economic welfare. The consumer surplus is larger than it was without the restricted exports (it is now the area AJP1), the producer surplus is smaller than it was without the restricted exports (it is now the area P1HF plus the area KLHJ. The first area (P1HF) is producer surplus as if the farmers sold all of their products to the domestic market, while the second area (KLHJ) is the extra profits the suppliers get from selling the quota of exports. Total welfare is smaller than without the restricted exports (it is now the area AJHF+KLHJ). There is a deadweight loss (a loss of total welfare arising from the restricted exports) equal to the area [BKJ + LCH] - these areas were part of total welfare with trade and no restricted exports, but have now been lost. The reduction in exports makes timber suppliers worse off, as well as society overall (in terms of economic welfare in total). However, timber consumers benefit in terms of higher consumer surplus.

Now consider the goals of the export quota. If the government is worried that domestic timber prices are too high, the export quota will lower the price (from PW to P1). If the government is worried that not enough timber is available and sold locally, the export quota will increase that quantity (from Qd0 to Qd1). It sounds like the export quota will have all the effects that the government might want. However, there is no free lunch here. Domestic timber producers are made worse off, and by more than the amount that domestic timber consumers gain (we know this because total welfare overall declines).

The negative impact on domestic timber producers is going to create a couple of negative incentives. First, at the margin it will dissuade timber growers from planting forests, because the return on investment will be lower (as timber prices are lower). Of course, that's not going to impact the market until 20-25 years into the future, so the current government might not care. Second, timber growers might prefer to leave their forests uncut, hoping that the export quota is lifted after the next change in government. If prices are low now, but there is an anticipated higher price in the future, then holding back supply might be a good strategy for some timber growers. That will have the opposite effect from what the government intends, because a reduced domestic supply of timber raises the domestic price, and decreases the quantity of domestic timber sold. This effect seems very likely to me.

The government needs to tread carefully, lest they create incentives that actually make the problem worse in the long run. Policy alternatives that encourage timber supply, rather than discouraging it, are likely to be more effective overall.