Inventory and Industry Consolidation
Purpose, Goals and Literature
The purpose of this proposed project is to extend t he ongoing
project, “Price Behavior (and Forecasting and Elasticities)
in Pulp and Paper Industry.” This price behavior project was
awarded in August 2001. We expected to complete the project by
As can be seen from our annual reports, we have been making
significant progress in the existing price behavior project. In
particular, we have constructed a sophisticated project web site.
On this web site, we regularly update price charts for
containerboard and pulp, including price charts for recent years as
well as historical price movement for twenty years. More
importantly, we have built real-time forecasting tools on the web
site for the industry. These forecasting tools can be used for
short-term forecasting on sales, inventory and even prices. They
can generate online forecasts with graphs based on a user’s
specifications and can update the forecasts as frequently as the
user likes when new data become available. In addition, we have
constructed a large data base with hundreds of variables that are
useful in studying the pulp and paper industry.
On the research front, we have completed a report on the
industry review and a report on price forecasting, and have
submitted a research paper on demand estimation to the Journal
of Forest Economics. Currently, we are in the process of
estimating demand and price elasticities of containerboard using
simulation equation system model; and applying the recent advance
in demand study, the random coefficient discrete choice model, to
study the substitution pattern between different paper/board
grades; and employing non-linear forecasting methods, neural
network models, to improve price forecasting. During the two-year
period of this project, we have received numerous requests from
industry analysts, managers, and researchers in the related fields
for our reports/papers, data, and advices. We have also been
invited by the International Union of Forest Research Organization
to join their project.
As we enter the final year of this project, it becomes clear to
us that, first, after spending enormous amount of time in learning
to understand the industry and in collecting industry related data,
we are prepared to do more in-depth researches for this industry.
And second, based on our work in the existing price project, with
some additional time, we can substantially expand our project to
further investigate some issues that are very important for this
industry, and get a much better understanding of price
Therefore, we propose to expand the current research on price
behavior. Our research in the existing project has touched many
important aspects of price behavior; and yet these aspects are not
covered in the scope of the current price project. They include
price volatility, the structural impact of inventory on price
changes, the effect of industry consolidation on price volatility
and profit margin, and the cost effect of price volatility and its
impact on vertical integration. We believe that these questions are
very important both for the industry and for academic research, and
they are well worth a thorough investigation. In addition, since
the existing project focuses explicitly on the containerboard
sector, studying these new issues will also move our research into
pulp and paper sectors.
We propose to complete the extended research on price behavior
in less than two years. The proposed research will be conducted by
a smaller team that mostly consists of members in the existing
price project. With only a portion of the time and the cost of the
existing price project, we expect to produce the same amount of
outputs (reports and papers).
The proposed project will proceed in four dimensions in order to
deepen and widen the scope of the existing price behavior
Dimension I: Price Volatility –
The first dimension is to study the dynamics of price volatility in
order to understand the underlying processes that drive such
volatilities. As can be seen in the following graph, in the long
term, the price movement of linerboard displays substantial
fluctuations (and the volatility of pulp price is even larger).
This property of volatility is known as time-varying volatility,
which has crucial implications for risk management and pricing in
any market. It also has direct implications for forecasting of
future prices. The forecasting models utilized in the existing
price project do not allow for the possibility of incorporating
time-varying volatility dynamics into the forecasting functions.
Our objective is to study volatility and risk in the pulp and paper
industry by utilizing recent econometric methods that allow one to
model directly the time-varying volatility and subsequently utilize
these models in forecasting both the price dynamics and future
volatility in the market. To our best knowledge, there is one
study, Fromson (1997), on price volatility in pulp and paper
industry. Fromson studies the volatility in pulp prices, but does
not model volatility directly.
In the existing project, we have focused on the price level and
price responses to other economic factors, not the price volatility
per se. However, the dynamics of price volatility reveal additional
information on price movement, and thus have important values both
to academics and to the industry. Moreover, the volatility dynamics
in prices can be used to generate advanced models to improve the
forecasting of long-term price movement. In addition, the dynamics
of price volatility can provide some basic information on the need
for the pulp and paper industry to hedge risks such as developing
or expanding futures markets.
Dimension II: Inventory and Short-term Price
Changes – The second dimension of the proposed
project is to build structural models to predict short-term price
changes. Price changes directly cause price volatility, and long
term price fluctuation is a result of short-term price changes.
Obviously, price volatility is affect by a large array of variables
from demand side and supply side. We have been studying these
effects using complicated structural econometric models in the
existing price project. However, as can be seen in the following
graph, short term price changes can have a very different pattern.
For example, in a two-year period from 1998 to 2000, prices only
changed 3-4 times.
It is generally difficult to use other economic factors to
predict price change in a short term such as next month because of
the timing of the data availability. Also, usual forecasting
methods generally cannot estimate the probability of price change.
Therefore, it is desirable to have a structural model to predict
price change based on some leading indicators. Such a model can
provide very useful information for the industry in production
planning (for example, in planning downtime). Based on our findings
in the current project, an inventory change generally occurs ahead
of a price change. Thus inventory changes cause price changes in
some causality sense. Since no study exists about the short-term
effect of inventory on price in the pulp and paper industry, we
will model the probability of price decrease or increase based on
inventory. This is also a natural extension of our existing work on
price forecasting, i.e., from forecast price to forecast the
probability of price change.
Dimension III: Price Effects of Industry
Consolidation – The third dimension of this
proposed project is to examine the effect of industry consolidation
on price. We will specifically investigate whether the
consolidation has any effect on price level, price volatility, and
profit margin. There is a vast literature about the effect of
market concentration on the price and price-cost margin. However,
the existing studies mostly cover airline, banking, advertising,
gasoline and grocery retailing industries; or they are based on
cross industry data. There is no major study on these issues for
the pulp and paper industry.
It is known that industry consolidation has two potential
effects: a higher price and/or a lower cost (higher production
efficiency). Clearly, the latter effect is desirable from any
prospect. Although consolidation becomes a hot topic in recent
years in the paper industry, its effect on price, cost, profit
margin, and price volatility is still largely unknown.
In the existing project on price behavior, we have touched these
issues indirectly. Based on our preliminary results from the
structural demand/supply model, consolidation in the containerboard
industry does not show any effect on price level. This finding is
not surprising given the relatively low concentration in the
paperboard industry. As shown in the following graph, based on the
concentration measured by the percentage of capacity of the top
four producers in the total industry capacity, the paper and
paperboard industry is still not highly concentrated.
If consolidation has not increased the price, then it is natural
to ask whether it has resulted in lower costs and/or lower price
volatility. If this is the case, the consolidation has positive
effects in improving production efficiency. Therefore, this study
has important implications for the industry as well as for the
government regulatory agency.
Dimension IV: Price Volatility and Vertical
Integration – The final dimension of this
proposed project is to study the strategic decision of vertical
integration (e.g., a paper/paperboard company takes over a pulp
company), specifically the impact of price volatility. It is known
that transaction cost is a main reason for vertical integration.
Price volatility represents a large portion of transaction costs
for downstream producers. For example, excessive volatility of pulp
price will create a large degree of uncertainties for paper and
paperboard producers and thus result in a large transaction cost.
If this is the case, it is desirable for paper and paperboard
producers to vertically integrate with pulp mills.
There have been a number of papers that examine vertical
integration in the pulp and paper industry. Ohanian (1994) studied
historical pattern of vertical integration from 1900 to 1940. The
most recent study is done by Melendez (2002) in her Ph. D.
dissertation. Although these studies examine the effect of
transaction cost on vertical integration, the effect of price
volatility is not explicitly investigated. Our study of the effect
of price volatility as a transaction cost on the decision of
vertical integration will provide insight on whether a vertical
merger would be more cost effective and logistically efficient.
In summary, these research dimensions proposed are natural
extensions to the existing price behavior project. Moreover, each
dimension is also internally connected with each other centered at
price. Building on these two projects, we will get a fairly
detailed picture of price behavior, from its movement and its
volatility (as well as the causes) to how we can predict them and
how the industry can do about it (consolidation, vertical
integration, or other such as inventory and downtime
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Group Discussion Paper 91-3, Antitrust Division, Department of