Industrial Price Formation

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Contributions to Economic Analysis 158, North-Holland, 1986, ISBN:  978-0444701022, LCCN: 86019609.

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By developing, analyzing and empirically applying models of industrial price formation, in particular in open economies, this books shows how models that have been derived from the micro-economic theory of producer and consumer behavior, can actually help to explain price formation in industries. The models will be applied to data for the Netherlands in the period 1961-1979.

There are several reasons why it is useful to study industrial price formation and to use a micro-economic theory. Firstly, application of models of industrial price formation may give an answer to questions as: do more concentrated industries have higher profit margins than less concentrated industries?; are prices in more concentrated industries less flexible than prices in less concentrated industries?; does strong foreign competition lead to low profit margins and to lower price increases? Secondly, existing models of macro-economic or industrial price formation are often constructed ad hoc, with little theory and with many ‘plausibility’ arguments. In general, this yields little interpretation of the coefficients and thus hardly any restrictions. On the contrary, a micro-economic approach does give a clear interpretation to the coefficients and a theoretical basis to the inclusion of variables. For example, in studies of industrial price formation the domestic market share (or its complement, the foreign market share) is often used as an explanatory factor of the price-cost ratio; the argument is that a low value of the domestic market share means that foreign competition is heavy, which leads to low profit margins. This ad-hoc approach can easily lead to circular arguments, since the domestic market share depends in turn on the ratio between domestic prices and foreign prices. In Chapter 6 of this book it is shown how this variable arises from a micro-economic model, how its coefficient depends on the elasticity of substitution between domestic and foreign products, and that, according to the theory, this coefficient is positive. The approach followed in this book can be used to answer questions surrounding the differences between concentrated and less concentrated industries, and to examine whether strong foreign competition leads to low profit margins and lower price increases.

The book consists of three parts. In the first part the relation between costs and prices is studied with an input-output model and a model of historic-cost pricing. In the second part price formation under pure competition is studied: the law of one price is tested, and a general-equilibrium model of price formation in a small open economy is constructed and estimated. In the third part price formation under imperfect competition is studied with both partial and general-equilibrium methods; it includes a theoretical basis for a price equation that is much used in industrial-organization studies, an analysis of the relation between marginal cost, average cost, and capacity utilization, a treatment of the effects of market structure, and a general-equilibrium analysis of price formation under imperfect competition.

Part 1. Cost and Prices

Part 1 (Chapters 2 and 3) deals with the transmission of price changes through the economy if there are constant technical coefficients of production and firms set their prices by adding a constant mark-up to average cost. I assume that the prices of the primary inputs are exogenous, so that price changes are transmitted only through intermediate cost. In Chapter 2 the properties of a static and a dynamic model are studied. In Chapter 3 a version of the dynamic model is applied to price formation in the Netherlands; the effects of changes in primary-input prices are dynamically simulated.

Part 2. Price Formation under Pure Competition

In Part 2 (Chapters 4 and 5), price formation under pure competition is studied. In Chapter 4, I analyze the law of one price for a small open economy. I assume that each tradable domestic product is traded in a perfect world market, so that the foreign price (measured in domestic currency) is equal to the domestic price. Because of the small-country assumption, we can interpret this equality as a causal relation: the foreign price determines the domestic price. The equality of foreign and domestic prices is important in monetarist models of the balance of payments [Johnson (1972, p. 153-4)] and in `Scandinavian’ models of price formation [Aukrust (1970, 1977), Edgren, Faxén, and Odhner (1970), and Calmfors (1977)]. The law of one price is analyzed for five commodity groups; the results show that the law of one price holds only for Fuels. Also the effects that aggregation has on testing of the law of one price are analyzed.

A possible explanation of the failure of the law-of-one-price model is that domestic and foreign products are not perfect substitutes. In Chapter 5, I construct a general-equilibrium model where domestic and foreign goods are not perfect substitutes; the law of one price is a limiting case of this model. I show that if a country is small and open, then the prices of foreign goods are exogenous, but the prices of domestic goods are not exogenous. The result rests on the fact that exports of a small open economy are small as compared to income of the rest of the world. After specification of consumer preferences and producer technology by two-stage CES functions I estimate the model on the same data as have been used in Chapter 4. The empirical analysis shows that actual price changes are better explained by this model than by the law of one price.

Part 3. Price Formation under Imperfect Competition

Part 3 (Chapters 6-9) deals with price formation under imperfect competition. In most of this part I assume that all producers in an industry act in complete collusion, i.e. they form a monopoly. This assumption makes it possible to concentrate on the influence that foreign competition and competition between industries have on price formation. I also assume that prices of foreign products are exogenous.

I derive in Chapter 6 an equation that relates the price-cost ratio of a monopolist to the ratio of domestic sales and competing imports. The monopolist produces under constant returns to scale a consumer product for which there exists a close foreign substitute; these two products are called two variants of the same good. Consumers allocate their budget in two stages: first they allocate the total budget to goods, and then for each good they allocate the expenditure on it to the domestic and the foreign product. I assume in this chapter that the price elasticity of demand for the good is equal to -1. Application of the theory of two-stage budgeting then gives that the price elasticity of demand is a function of the domestic-sales/competing-imports ratio; because the price-cost ratio of a monopolist depends on the price elasticity of demand, the relation between price-cost ratio and domestic-sales/competing-imports ratio then follows. The coefficient of the domestic-sales/competing-imports ratio must be positive and is an increasing function of the elasticity of substitution between the domestic and foreign products; thus the higher the foreign market share is or the more substitutable the domestic and foreign products are, the lower the price-cost ratio is.

A similar foreign competition variable (often the market share of foreign suppliers) appears in many empirical studies on industrial organization; see Esposito and Esposito (1971), Khalilzadeh-Shirazi (1974), Pagoulatos and Sorensen (1976a, 1976b), Hart and Morgan (1977), Jones, Laudadio, and Percy (1977), Caves and Porter (1978), and De Wolf (1981, 1982). Most of these studies contain cross-section regressions with the profit share as the dependent variable and the foreign market share together with market-structure variables (such as concentration ratio and barriers to entry; see below) as independent variables. The empirical results show that foreign competition has had a strong negative influence on the mark-up in the industries Other food, Textiles, and Clothing and leather.

In Chapter 7, the model of Chapter 6 is generalized: the restriction on the price elasticity of demand for the good is now lifted and the demand for goods modeled by means of the Rotterdam system, price formation by a monopolist who produces producer goods or both consumer and producer goods is studied, and the relation between marginal cost, average cost, and capacity utilization is analyzed. This leads to a model where the price of an industry is determined by average variable cost, average fixed cost, capacity utilization, the domestic market share on the consumer market, the domestic market share on the producer market, and the budget and cost shares of the good (i.e. the share that domestic and foreign producers have in respectively consumer expenditure and producer cost). The price equation that results from these extensions is estimated for 24 industries in the Netherlands. The empirical results show that average variable cost is the most important determinant of the domestic price; average fixed cost and the budget/cost share are important in about half of the industries; and capacity utilization and the domestic market share are important in about a third of the industries.

In Chapter 8, I investigate the relationship between market structure and price formation, in particular the relationship between degree of concentration and the mark-up. Theoretical analyses of the relation between market structure and price formation have been made by Saving (1970), Modigliani (1958), and Cowling and Waterson (1976). These models are combined with part of the analysis of Chapter 7 into a model in which the price-cost ratio depends on concentration, barriers to entry, the domestic market share, and the budget/cost share. The empirical results show that there is no relation between concentration and profit margins. I also derive a relation between price, cost, demand (represented by the domestic market share and the budget/cost share), and concentration; it appears from the empirical results that the more concentrated an industry is, the more its price reacts to changes in capacity utilization and the less its price reacts to changes in the budget/cost share.

Chapter 9 deals with the general-equilibrium structure of the model of Chapter 7, i.e. the comparative statics when all transmissions via cost and demand are taken into account. For some two-good cases I show that increases in exogenous primary cost, foreign prices, and income lead to an increase in domestic prices. The empirical analysis for the 24 industries shows that in most industries primary cost and foreign prices are about equally important determinants of price formation.

About the digital edition

The text corresponds as closely as possible to the original printing, but owing to the different troff versions used (respectively Unix-V7 Troff and Groff), there are differences in the line breaks. The original page breaks have been preserved. Also, printing errors have been corrected, and the figures have been remade with Pic and Grap, which were not available when the book was written around 1983.

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