Transcript The Dynamics of Trade and Competition Natalie Chen, Jean Imbs

The Dynamics of Trade and
Competition
Natalie Chen, Jean Imbs, Andrew Scott (2007)
Theory
• Inspired from Melitz and Ottaviano (2005).
• Links prices, productivity and markups to the
number of competing firms.
• Trade openness, as it affects the market
structure, influences firm level performances
in a way that depends on the time horizon
considered (pro-competitive effects in the SR
vs. ambiguous effects in the LR).
Demand
• L consumers, supplying one unit of labour.
• Preferences are defined over a continuum of sectors indexed by i. Utility
of consumption in each sector is derived from preferences over a
continuum of varieties indexed by u Є (0,1).
• The representative agent maximises:
(1)
• Solving this program yields the following inverse demand for each variety
u:
(2)
• Also implies the following aggregate demand for variety u in sector i:
(3)
Demand (cont.)
• Observe that the individual consumption in each sector can be written as:
(4)
where N is the measure of consumed varieties, with average price:
• Substituting (4) in (3) yields the aggregate demand for variety u in sector i:
(5)
Demand (cont.)
• Conclusion:
(6)
This price goes down with tougher competition in the sector,
which implies higher N (with
) or smaller average price.
Following Ottaviano, Tabuchi and Thisse (2002), the price
elasticity of demand changes with the number of competing
firms (one variety per firm). Then markup depends on N as
well.
=> Contrary to models with CES preferences, elasticity and
markup are not exogenously fixed (but are affected by trade
openness as N denotes both domestic and foreign firms).
Variable markups are more consistent with empirical
evidence.
Supply
• Single input, which is internationally immobile: labour, with unit cost c,
different across countries.
• Prior to entry, firms face uncertainty on their unit cost of production.
• Entry cost (≈irreversible investment), which is country-specific and varies
with the degree of openness (fE ≠ fE*). Assume fE* = λ (τ*,τ) fE(τ) and fE’>0.
=> contrasts with Melitz and Ottaviano (2005), who consider a fixed entry
cost, which does not allow for ambiguous trade effects in the LR.
• Firm productivity is revealed: this is a draw from a common cost
distribution G(c) with support on [0,cM] or [0,cM*]. Cross-country
productivity differences. Productivity differences across firms as well.
• Then, production and export decisions are made. Firms can sell to
domestic and foreign markets. τ* > 1 denotes cost of domestic export to
foreign market (symmetrically, τ > 1 denotes cost for foreign goods
entering the domestic economy). Firms, which cannot cover their marginal
cost, exit.
• In the SR, firms cannot change their location.
Supply (cont.)
Domestic market
Foreign market
Producer
Domestic firm
Foreign firm
Domestic firm
Foreign firm
Unit cost of
the marginal
firm
cD
cX* = cD/τ
cX = cD*/τ*
cD*
Price ensuring
zero sales
p(cD) = cD
p(cX*) = cD/τ
p(cX) = cD*/τ*
p(cD*) = cD*
Production
choice
qD(c)
qX*(c)
qx(c)
qD*(c)
Supply (cont.)
• Surviving firms maximise their profits facing the demand function (3).
Monopolistic competition implies that the average price level and number
of firms are taken as given.
• A domestic firm with productivity c will solve the following programmes:
F.O.C.
(7)
(8)
Supply (cont.)
• Following Melitz and Ottaviano (2005), the costs for firms that produce for
the domestic market or that export follow a Pareto distribution.
• In the domestic economy, optimal pricing and distributional assumptions
yield the following average sectoral price index and average cost:
(9)
(10)
• Average sector markup is given by:
(11)
• The same relation holds for the foreign economy, where prices, markups,
costs and productivity all depend on the value of the cost for marginal firm
still in activity (cD*).
Equilibrium
• Demand side
• Need to solve for the number of active firms in both markets, which can
be derived from the threshold costs of the marginal firm in both markets.
• Using (6), one get:
(12)
Symmetrically:
(13)
• Combining this with the average sectoral price index (derived earlier)
yields the number of firms selling in each market:
(14)
(15)
Equilibrium (cont.)
• (14) and (15) describe the demand side of the
economy, which is invariant to trade costs.
• They imply a negative relationship between the
number of active firms supported by the market and
the cost cut-off, as high costs (i.e. high values for cD)
=> high prices, limited demand and a limited number
of firms (and varieties).
Short-run supply
• In the SR, the number of firms in each market is exogenous, but firms still
decide whether to produce or not and which markets to supply.
• 3 types of firms: (i) high cost firms, which do not produce (but cannot
relocate); (ii) lowest cost firms, which produce for domestic and foreign
markets, and (iii) intermediate firms, which produce only for the domestic
market.
• The supply side of the economy is given by:
(16)
(17)
• Production decisions are affected by changes in transport costs. Positive
relationship between the number of active firms and the cost cut-off.
Short-run supply (cont.)
• In equilibrium, N rises and cD falls in response to a fall in transport costs.
• Price, costs and markups (which all depend on cD in the model) fall as well.
Long-run supply
• In the LR, location decisions and the number of firms active in each market
are endogenous:
(18)
(19)
• Under Pareto assumption, using free entry conditions (i.e. zero profits)
gives the cut-offs in both markets:
(20)
(21)
Long-run supply (cont.)
• In contrast to the SR, the cost of the marginal firm (i.e. cD) is not affected
by the number of active firms (due to endogenous entry and exit).
• In the LR, the cost cut-off depends on the distribution of costs, the level of
fixed costs, market size and trade costs.
Long-run supply (cont.)
• Consider (20) and (21) :
• If fixed costs are equal and constant (i.e. λ(.)=1 and fE(τ)=fE), a fall in
domestic trading costs leads to an increase in marginal costs: N falls and cD
rises (higher prices and markups and lower productivity) => exact opposite
of the SR impact of falling trade costs => anti-competitive effects.
• In the LR, firms relocate to more protected foreign markets (the fall in
trade costs and the lower degree of competition overseas makes it more
attractive to serve the domestic market through exports).
Long-run supply (cont.)
• Consider (20) and (21) :
• If fixed costs are variable such that fE=fE(τ) and fE’>0, a decrease in τ
implies a decrease in ø(τ), which induces a downward shift in the
horizontal line (increase in N and pro-competitive effects).
• The overall net effect of the impact of trade liberalisation in the LR is
ambiguous and depends on the relative weight of both opposite effects.
Predictions
• As economy opens up, more foreign firms export to domestic
market => increase in the number of competing firms at
home.
• Simultaneously lowers mark-ups because of higher perceived
elasticity of demand (lower market shares).
• Also raises productivity, as with lower prices, fewer firms can
break-even.
• Both channels reduce prices at home.
• In the long run, domestic firms can chose where to locate. A
closed economy is attractive, as the number of competing
firms is limited. It is also cheaper to export to home market
from there. Domestic firms relocate abroad => trade effects
may revert in the long run.
Estimation strategy
• Key indicators of trade openness in the model (τ and τ*) are unknown =>
replaced by model-implied observable variables: import shares (Ѳ and
Ѳ*), which depend only on transport costs and relative productivity.
• By definition:
• Pareto distributional assumption implies:
• And by symmetry:
Prices
• In the SR, equations (12) and (13) give:
(22)
• N is unknown, but data on D, the number of domestic firms producing for
the home market (with D = NSR (cD/cM)k and D = ψ(τ,τ*)N, with ψτ <0) .
Prices (cont.)
• In the LR, equations (20) and (21) give:
»
(23)
(23)
• The effect of openness is no longer conditional on N and depends on
whether λ is allowed to depend on openness.
• Larger markets have lower prices.
Prices (cont.)
• Combining SR and LR in a specification that allows the LR impact of
openness to vary from its SR impact : ECM model
• Variables must be integrated of order one (I(1)) and cointegrated.
• Difference in difference approach: all variables are expressed in first
differences/identification of differential effects across the same sector i in
different countries.
• Intercepts to control for cross-country and cross-sector variations in
technology (cM≠cM*).
Markups
• Relative markups depend directly on relative cut-off costs
(just as relative prices):
Productivity
• The model was specified in terms of unit costs (c).
• Average sectoral labour productivity is approximate by w/c, where w
denotes nominal wage at the sector level => strong assumption, as it
implies no difference in capital costs across countries (omitted variable
bias?):
• Perfect labour mobility in a same sector implies
• Using equation (22) yields an expression for relative productivity in the SR:
Productivity
• Using equation (23) yields an expression for relative productivity in the LR:
• Combining both effects in a single specification gives the following ECM
model:
Econometrics issues
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Stationarity
Lagged Dependent variables
Nominal Prices
Country pairs/Heteroscedasticity
Endogeneity
Stationarity
• Estimating an ECM model requires variables, which
are I(1), thus their first difference will be stationary.
• Unit-root testing strategies.
• Failure to reject the null of a unit-root => ECM yields
more efficient estimates.
• Risk: unit-root tests lack in power (tend to tell there
is a unit root when there is no unit-root).
• Equations will be estimated with and without the
ECM specification.
Lagged Dependent Variables
• Controls for sluggish price adjustment :
coefficient on lagged price = gradual effect of
price adjustment.
• Risk of correlation between the lagged
dependent variable and individual specific
effects => OLS estimated could be biased and
inconsistent.
• Solution: Generalised Method of Moments
(GMM).
Nominal prices
• Model of real relative prices at the sector level
• Need to purge the effects of nominal aggregate influences, which may
correlate with openness (Romer, 1993)/omitted variable bias
• Inclusion of aggregate price indices (P) for each country:
• Assumption: monetary shocks affect all sectors homogeneously (or at
least if some heterogeneity exists, it is uncorrelated with openness)
Country pairs/Heteroscedasticity
• Estimation in differences in differences: crosssection of bilateral international differences in
all the variables of interest.
• Measurement error (heteroscedasticity, i.e.
the variance of the error terms is no longer
constant) => solution: country fixed effects).
• Country pair/sector specific intercepts in all
estimations.
Instrumentation strategy
• Need of instruments for import shares, as the
degree of import penetration can be
influenced by many factors (including prices,
productivity).
• Identification/what drives international
differences between European countries and
at the sector level?
Instruments
• Ratio of import weights to their value (excluding domestic prices from
computations): import penetration in sector i and country j is
instrumented with the average bulkiness of US imports in the same sector,
where exports into the US from j are excluded from the computations of
total weight and value.
• “Gravity” variable:
where wjk denotes the inverse of distance between countries j and k
• Number of anti-trust cases in ECJ interacted with a sector-specific index of
NTBs. Variables vary across industries and over time.
• Dummies for European policy changes: Single Market 1992 and the Euro
1999.
• Taken together, these instruments explain more than 50% of variation in
import shares.
Data
• Cover 1989-199, seven European countries (Belgium,
Denmark, France, Germany, Italy, the Netherlands, Spain) and
10 manufacturing sectors.
• Price data from Eurostat.
• Labour productivity from OECD.
• Markup data from BACH. Markups are computed as follows:
• Summary statistics: some sectors opened up than others,
within each sector, some countries opened up more than
others.
Results
Robustness
• Control for nominal exchange rates (varying across sectors).
• Control for factor intensity (Heckscher-Ohlin argument =>
rising import shares and falling prices in sectors with shrinking
domestic production).
• GMM estimator.*
• Specification in deviation from benchmark country (Italy, for
its lack of openness).*
• Distinguish EU and non-EU imports.
• Non-linearity in openness effects.*
• Instrumentation of the number of firms.
*LR anti-competitive effects are muted
Summary
• Model-implied observable variables and specifications.
• Theoretical are supported by data.
• In the short-run, import penetration has standard procompetitive effects: negative and significant impact on
manufacturing prices; positive and significant impact on
manufacturing productivity; and negative and significant
impact on profit margins.
• Effects revert in the long run, as protected economies
overseas become attractive locations from which to export to
the liberalised domestic economy.
• Effects of foreign openness and of relative numbers of active
firms are also consistent with theory.
Summary
• Focus on the microeconomic channels through which trade
has pro-competitive effects on prices, markups and
productivity.
• Macroeconomic channels through which openness affects
trade are overlooked.
• Also, increasing openness contains wage growth and lowers
inflation (labour market channel).