Estimating Welfare Effects from Supply Shocks with Dynamic Factor Demand Models

This paper examines how the demand for commodities adjusts to supply shocks, and shows the importance of capturing this adjustment process when calculating welfare effects. A dynamic capital adjustment model for U.S. softwood stumpage markets is developed, and compared to a traditional lagged adjustment model. The results show that timber markets in the U.S. adjusted to the large supply shock of the late 1980's over a 5 to 8 year period. Our short-run price elasticity estimates are similar to the existing literature, ranging from -0.002 to -0.253, although our estimates show that the demand is substantially more elastic in the long-run, with long-run elasticity estimates ranging from -0.134 to -0.506. If this adjustment in the demand function is taken into account when calculating welfare effects, the effects of the supply shock in timber markets of the late 1980's on consumer surplus declines by over 50% compared to the estimated effects when using the short-run model, and the total welfare effects decline by 37%.