The Dynamics of Trade and Competition

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The Dynamics of Trade and Competition

• Natalie Chen (Warwick CEPR)
• Jean Imbs (Lausanne CEPR)
• Andrew Scott (London Business School CEPR)

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Motivation

• Academic audiences attribute decline in global
  inflation to improvements in central bank
  practice
• Business audiences tend to attribute the decline
  to globalisation and technology

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You can see why.
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I argue that the most important and most unusual
factor supporting worldwide disinflation has been
the mutually reinforcing mixture of deregulation
and globalization, and the consequent significant
decrease in monopoly pricing power. K. Rogoff,
2003
An issue worth investigating.
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Globalisation and Inflation What are the links?

• Substitution towards cheaper imports brings down
  price level and during transition lowers
  inflation
• Increasing competition narrows markups and lowers
  price levels and lowers inflation during
  transition
• Increasing competition spurs productivity growth,
  reduces costs and lowers inflation during
  transition
• Increasing competition restrains wage growth and
  lowers inflation
• Increasing openness increases importance of
  exchange rates and reduces effectiveness of
  inflation surprises
• Increasing competition reduces output gap and
  reduces inflation bias

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Globalisation and Inflation Focus of this paper

• Substitution towards cheaper imports brings down
  price level and during transition lowers
  inflation
• Increasing competition narrows markups and lowers
  price levels and lowers inflation during
  transition
• Increasing competition spurs productivity growth,
  reduces costs and lowers inflation during
  transition
• Increasing competition restrains wage growth and
  lowers inflation
• Increasing openness increases importance of
  exchange rates and reduces effectiveness of
  inflation surprises
• Increasing competition reduces output gap and
  reduces inflation bias

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What this paper does
Outlines a theoretical model with rich
microeconomic channels through which trade exerts
pro-competitive effects on productivity, prices
and mark ups Combines model with EU sectoral
data and includes control for aggregate nominal
influences (and in particular monetary policy) to
isolate micro pro-competitive effects.
Difference in Differences estimation
Differentiates between short run and long run
effects. Drastically different in theory
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Contribution Model implied observable variables,
model implied specifications. Two-country
version of Melitz-Ottaviano (2005) with
international differences in productivity, in
wages and in trading costs. Openness (import
penetration) has negative and significant
impact on manufacturing prices positive and
significant impact on manufacturing productivity
(truncation effect) negative and significant
impact on margins (pro-competitive effect)
Effects revert in the long run non-liberalizing
country becomes an attractive base camp from
which to export to liberalized economy.
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• Plan
• Theory
• Estimation Strategy
• Data (markups)
• Main Results

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• Plan
• Theory
• Estimation Strategy
• Data (markups)
• Main Results

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Theory Objectives Introduce theoretical
channels between prices, productivity and mark
ups Motivate our measures and our
estimation. Ingredients Imperfect competition
with elasticity of demand depending on number of
firms Ottaviano, Tabuchi and Thisse (2002).
Then mark ups depend on number of firms as
well. Firms with heterogeneous productivity, and
fixed cost of entry. Productivity is revealed
after cost is paid, and non-productive firms
exit. Melitz (2003)
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Mechanism Liberalizing domestic economy lowers
tariff. Import share rises as more foreign firms
export to domestic market. Rising import share
leads to increase in number of firms. Immediately
lowers mark ups. Also increases productivity as,
with low prices, fewer firms make the cut. Both
channels reduce prices. In long run, firms can
choose where to locate. Closed economy
attractive, because more protected. Also, has
become cheaper to export to domestic market from
there. Firms relocate abroad . Number of firms
now falls, with opposite end effects on prices,
margins and productivity. Inspiration Extension
of Melitz (2003) and Melitz and Ottaviano (2005).
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Demand
Inverted demand for variety u in sector i
Implies total demand for variety u in sector i
where N denotes total number of firms (domestic
and foreign), and L is market size (number of
consumers). denotes foreign country.
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Supply Labor is sole input, with unit cost c,
unknown ex-ante, different across countries. t
denotes cost of foreign export to domestic market
t cost of domestic export to foreign
market. Domestic profit maximization implies
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Key Melitz-Pareto simplification Assume c
follows Pareto distribution in 0,cM, with
parameter s. We further assume c follows Pareto
with parameter k in 0,cM, cM ? cM. Optimal
pricing and distributional assumptions give
average sectoral price and costs
Where cD is cost for marginal firm still in
activity, i.e. the one that verifies p(cD)
cD By definition,
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Equilibrium Need to solve for cD and the number
of firms.
Marginal firm still in business is pricing at
cost, and is also the one with highest price
(lowest productivity). Nonnegativity constraint
on demand binding for this form and so
Thus
Negative, downward sloping relation between
number of firms supported by market N and
threshold cost level. High costs means high
prices, limited demand and few varieties.
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Short Run Supply No location decision in the
short run. The number of firms in each country is
given but firms can still choose to participate
in each market, i.e. choose to produce for
domestic and/or for foreign market. In other
words, the number of firms operating in each
market is endogenous (since decision to export is
endogenous) but number of firms located in each
market exogenous. By definition
Traces upward sloping relation between N and cD.
The larger costs, the larger the number of firms
that choose to operate
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A fall in t increases N for a given level of cD.
A fall in trading cost means more firms will be
operating in the domestic market, as foreign
exporters become active there. In equilibrium,
N increases and cD falls prices, costs and
markups fall.
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Long Run Supply Long run by definition means
location decisions are endogenous, i.e. so is the
number of firms in each country. Free entry
conditions in both countries
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Simplifies (under Pareto assumption)
Now cD is independent on N or N. Falling trading
cost t means higher cD. I.e. higher prices, costs
and markups. Relocation effect.
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Relocation means bilateral trade liberalisation
has anti-competitive effects in the long run
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• Plan
• Theory
• Estimation Strategy
• Data (markups)
• Main Results

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Openness Introduce import share ?
We have
By symmetry
Useful to rewrite

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From Theory to Estimation
Prices
Markups
Productivity

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• Econometrics Issues
• Intercepts
• Estimation is differences in differences, i.e.
  international differences in sectoral growth
  rates.
• Country pair/sector specific intercepts
• Nominal Prices
• Model is one of real prices. Control for
  aggregate prices as well, and thus for any
  (aggregate) influence on nominal prices.
• Lagged Dependent Variables
• How long does the short run last? Arent prices
  sluggish?
• Include lagged dependent variables. Not crucially
  affecting conclusions.
• (Correct for bias induced by lagged dependent
  variables with fixed effects using Arellano-Bond)
• Stationarity
• Endogeneity

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• Instruments for import shares
• Ratio of imports weights to their value, across
  countries, sectors and over time.
• Gravity inspired variable

where ?jk denotes the (inverse of) distance
between countries j and k. 3) Transport costs,
as measured by differences between CIF and FOB
values. Taken together, instruments deliver R2
above 40. 4) Dummies Single Market 1992 and
Italian Lira re-entry 1996.
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• Plan
• Theory
• Estimation Strategy
• Data (markups)
• Main Results

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Data Data cover manufacturing sectors only. 7
countries, 10 sectors, 1989-1999. Belgium,
Denmark, France, Germany, Italy, the Netherlands,
Spain Sectoral PPI from Eurostat Labor
productivity (Real Value Added per Worker) from
OECD STAN Mark up data from Bank for the
Accounts of Companies Harmonized
(BACH). Homogeneous layout for balance sheets,
profit and loss accounts, investment and
depreciation.
where Variables Costs materials, consumables,
staff
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• Plan
• Theory
• Estimation Strategy
• Data (markups)
• Main Results

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Summary Developed simple theory suggesting
import shares should affect prices negatively,
via increased productivity and lower
markups. Showed conjecture is supported by the
data. Rising import shares lower prices, because
they increase productivity and lower
margins. Effects of foreign openness on domestic
variables, and of relative numbers of firms are
consistent with theory. Crucial implication of
model is that effects are opposite in the long
run. Surprisingly strong evidence supporting that
conjecture.
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Robustness Nominal Exchange Rates Factor
Endowments GMM estimators Benchmark (Italy) as a
treatment effect Origin of Imports
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What about Globalisation and Inflation?

• We ignored the macro channels through which
  openness affected inflation
• Dont examine labour market and impact through
  wage restraint
• Focus on how cheaper imports, lower markups and
  lower costs/greater productivity contribute to
  lower inflation as openness increases

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What about Globalisation and Inflation?

• Impact of greater openness in EU during this
  period has contributed to lower inflation
• Direct effect surprisingly small around
  0.1-0.2 per annum
• If believe the long run reversal effect then can
  also expect this effect to unwind and lead to
  higher inflation

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I guess its the central bankers that did it!