Pricing to Market, Implicationsempirical and Evidence

Introduction

After the huge resurgence of interest in Purchasing Power Parity in 1982, an increasing number of economists started using new econometric methods, such as cointegration and non-stationary panel methods, to test PPP. Rogoff (1996) had introduced the so-called PPP puzzle in his paper, which concerns the question that 'how is it possible to reconcile the extremely high short-term volatility of real exchange rates with the glacial rate (15 percent per year) at which deviations from PPP seem to die out?' (Rogoff, 1996, p. 664). To solve the PPP puzzle, numerous explanations arose including the core of this essay, Pricing to Market. The objective of this essay is threefold: (i) to explore and review the concept of Pricing to Market (PTM), (ii) to illustrate the implications of PTM for Purchasing Power Parity, and (iii) to analyse the empirical evidence of PTM. Initially, I will start with an overview of the concept of PTM in the first part of this essay, then go on to interpret the implications of PTM for the PPP hypothesis in the following paragraph and cover the empirical evidence concerning Pricing to Market in the last section.

Main body

Pricing to Market as a concept was first introduced by Krugman in 1987 to characterise the phenomenon of imported goods' prices staying the same or even increasing when the domestic currency appreciates. In other words, it implies that producers are capable of price discriminating among different international markets (Knetter, 1989). The fact that price discrimination for certain types of goods arise in the international goods markets may be due to the difficulty or absence of international arbitrage. Particularly, differing national standards (for instance, left-hand-drive cars are not sold in the U.K.) or monopolistic firms' ability may both impede international goods arbitrage (Sarno and Taylor, 2002).

Apart from literal interpretation, the concept of Pricing to Market could also be illustrated using the following partial equilibrium model of exporter behaviour taken from Knetter (1989). Assume an exporting firm selling to N international destinations and demand in each destination market has the same general form:

(1)

,

where s is the exchange rate (destination currency per unit of exporter's currency), p is the price in terms of the exporting firm's currency, v is a random variable which may impact on the demand, and qit denotes the quantity demanded by destination market i in period t. Then assume the exporter's costs are given by:

(2) ,

where Ct measures costs in exporting firm's currency units, the summation sums up all i (the destination markets), and δt ¬denotes a random (costs) shift variable in period t. The exporting firm's profit in period t can be shown as equation (3):

(3) .

Substituting the demand functions into the profit function and maximising this with respect to the price charged in each market in each period, we can get the following set of first-order conditions:

(4)

,

Where ct equals the marginal cost of production in period t (C' δt) and εit denotes the elasticity of demand in domestic currency price in destination market i. The system of equations in (4) captures the basic conclusion of price discrimination: the general marginal cost is equal to marginal revenue in each destination market. To be precise, 'price in the exporter's currency is a markup over marginal cost, with the markup determined by elasticity of demand in the various destination markets' (Knetter, 1989, p. 200).

In general, Pricing to Market makes the explanations for the Purchasing Power Parity puzzle more complete. However, the traditional explanation for the PPP puzzle is based on the presence of non-traded goods. After a large amount of evidence found from 1980s to 1990s, economists started to realize that 'real exchange rate fluctuations are mainly attributable to failures of the law of one price among traded goods' (Betts and Deverux, 2000, p. 216). Betts and Devereux's (1996) model demonstrates that Pricing to Market can generate the deviations from the Purchasing Power Parity at both individual and aggregate level. That is to say, when the exporters practice Pricing to Market in the destination market, changes in exchange rate have little impact on the price of imported goods with respect to local currency (Faruqee, 1995). Thus, the deviation of Purchasing Power Parity is generated by PTM. Also, the results from the model are consistent with Krugman's argument in 1990, suggesting that PTM is responsible for the real exchange rate volatility, dramatically. Precisely, in a large PTM sector, a depreciation of the currency does not tend to make customers spend more money on foreign goods than before. That is how the exchange rate response is magnified. Therefore, PTM takes the responsibility for the increase in exchange rate variability and the PPP puzzle as well. Basically, Pricing to Market can influence the Purchasing Power Parity in two ways. On one hand, it works as the frictions in international goods markets to impede the immediate response of domestic prices to the changes of exchange rates (Rogoff, 1996); on the other hand, it increases the volatility of real exchange rate.

The empirical findings on Pricing to Market are various and quite consistent across studies. Knetter (1989) presents a model of exporter behaviour which can permit the data to distinguish between three

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