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Effects of stochastic interest rates in decision making under risk: A Markov decision process model for forest management

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  • Zhou, Mo
  • Buongiorno, Joseph
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    Abstract

    Most economic studies of forest decision making under risk assume a fixed interest rate. This paper investigated some implications of this stochastic nature of interest rates. Markov decision process (MDP) models, used previously to integrate stochastic stand growth and prices, can be extended to include variable interest rates as well. This method was applied to Douglas-fir/western hemlock forests in the Pacific Northwest of the United States. An MDP model was used to find the harvest decisions that maximized the forest value of a stand in a particular state, given the price level and interest rate. This optimal policy was compared with the policy that would hold in the same context but with an interest rate fixed at its historical average. The results showed that when the interest rate was lower than its historical average, the best decision differed for 52 of the 192 possible combinations of stand state and price level. Assuming a fixed interest rate underestimated the forest value by 4% to 16% depending on the initial condition. However, applying the harvest policy derived with a fixed interest rate led to a loss of no more than 7% depending on the initial condition. Taking explicit account of the variability of interest rate in setting harvest policies had some unexpected ecological benefits.

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    Bibliographic Info

    Article provided by Elsevier in its journal Forest Policy and Economics.

    Volume (Year): 13 (2011)
    Issue (Month): 5 (June)
    Pages: 402-410

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    Handle: RePEc:eee:forpol:v:13:y:2011:i:5:p:402-410

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    Keywords: Risk Discounting Management Present value Optimization;

    References

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    1. Harry R Clarke & William J. Reed, 1989. "The Tree-Cutting Problem in a Stochastic Environment: The case of Age Dependent Growth," Working Papers 1989.01, School of Economics, La Trobe University.
    2. Alvarez, Luis H.R. & Koskela, Erkki, 2006. "Does risk aversion accelerate optimal forest rotation under uncertainty?," Journal of Forest Economics, Elsevier, vol. 12(3), pages 171-184, December.
    3. Alvarez, Luis H R & Koskela, Erkki, 2003. "On Forest Rotation under Interest Rate Variability," International Tax and Public Finance, Springer, vol. 10(4), pages 489-503, August.
    4. Morton, R., 1973. "Optimal control of stationary Markov processes," Stochastic Processes and their Applications, Elsevier, vol. 1(3), pages 237-249, July.
    5. Ching-Rong Lin & Joseph Buongiorno, 1998. "Tree Diversity, Landscape Diversity, and Economics of Maple-Birch Forests: Implications of Markovian Models," Management Science, INFORMS, vol. 44(10), pages 1351-1366, October.
    6. Thomas A. Thomson, 1992. "Optimal Forest Rotation When Stumpage Prices Follow a Diffusion Process," Land Economics, University of Wisconsin Press, vol. 68(3), pages 329-342.
    7. Margaret Insley & Kimberly Rollins, 2005. "On Solving the Multirotational Timber Harvesting Problem with Stochastic Prices: A Linear Complementarity Formulation," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 87(3), pages 735-755.
    8. Richard B. Howarth, 2009. "Discounting, Uncertainty, and Revealed Time Preference," Land Economics, University of Wisconsin Press, vol. 85(1), pages 24-40.
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