The Dynamics of Trade and Competition

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

School & CEPR)

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

You can see why….

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….

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

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

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

What this paper does

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.

Plan

• Theory

• Estimation Strategy

• Data (markups)

• Main Results

Plan

• Theory

• Estimation Strategy

• Data (markups)

• Main Results

Theory

Objectives:Introduce theoretical channels between prices,

productivity and mark upsMotivate 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)]

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).

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.

Supply

Labor is sole input, with unit cost c, unknown ex-ante, different across countries.

τ denotes cost of foreign export to domestic market – τ* cost of domestic export to foreign market.

Domestic profit maximization implies

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,c*M], c*M ≠ 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,

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.

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

A fall in τ 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.

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:

Simplifies (under Pareto assumption):

Now cD is independent on N or N*. Falling trading cost τ means higher cD. I.e. higher prices, costs and markups. Relocation

effect.

Relocation means bilateral trade liberalisation has anti-competitive effects in the long run

Plan

• Theory

• Estimation Strategy

• Data (markups)

• Main Results

Openness

Introduce import share θ

We have

By symmetry

Useful to rewrite:

From Theory to Estimation

Prices

Markups

Productivity

Econometrics Issues

• InterceptsEstimation 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? Aren’t 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:

Instruments for import shares

1) Ratio of imports weights to their value, across countries, sectors and over time.

2) Gravity inspired variable:

where ωjk 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.

Plan

• Theory

• Estimation Strategy

• Data (markups)

• Main Results

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

Plan

• Theory

• Estimation Strategy

• Data (markups)

• Main Results

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.

Robustness

Nominal Exchange Rates

Factor Endowments

GMM estimators

Benchmark (Italy) as a treatment effect

Origin of Imports

What about Globalisation and Inflation?

• We ignored the macro channels through which openness affected inflation

• Don’t 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

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

I guess it’s the central bankers that did it!