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For this task we consider some of the incentives faced by producers and their production decisions.

(a) According to an OECD report (2007, p. 19-20): “Illegal wood is not burdened by taxes, stumpage fees and expenses for compliance with forest and environmental regulations. It is therefore cheaper to produce than legal wood. … illegal logging is substantially more profitable than the legal kind and that there is therefore a clear financial incentive to engage in illegal activities.”

For questions (i) to (iii) below we will compare legal to illegal harvesting. For these questions assume that demand remains the same for both legal and illegal operators and assume that there are numerous competing firms with no barriers to entry or exit.

i. Harvesting mahogany was legal until 2001. With the aid of a diagram illustrate the profit maximising production decision of firms that were legally harvesting mahogany

ii. In 1999 the Brazilian government revoked 85% of harvesting licenses. However, there was little attempt to enforce the law; firms were able to sell mahogany in the guise of other types of timber and illegal trade was enabled by corrupt officials. Moreover, firms that operated illegally no longer needed to meet regulatory requirements and could avoid paying taxes. On the same diagram as (i) above, illustrate and explain the incentives and short-run profit maximising production decisions of firms that are illegally harvesting mahogany. (For this question assume that the total number of firms remains unchanged; firms that lose their license to operate legally are replaced by firms who operate illegally.)

iii. Now consider what happens if the Brazilian government starts to enforce the law to prevent illegal harvesting. What happens to the operating cost differences between legal and illegal harvesting firms? Explain your reasoning. (No diagrams are required for this question.)

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