A basic study of pricing to market

Introduction

Exchange rate is always changing, which can cause different relative price of traded goods among countries. However, when firms adopt PTM (pricing to market), price of trading goods does not change with the exchange rate, That may result in deviation from purchasing power parity theory. Many aspect of economy such as consumption, welfare distribution will change according to this behavior. This paper tries to illustrate the meaning and the effect of PTM with some theory and empirical evidence.

Definition and theories about PTM

Pricing to market(PTM) is a new definition emerged in mid-1980s.During that period ,US dollar has experienced a strong appreciation. However, it has been noticed that the price of import commodities in the US did not decrease according to the exchange rate changes. PTM represent the phenomenon of foreign firms maintaining or even increasing their export price when the currency of the importer country rises. (Krugman,1987) .PTM can also be understand as export firms set price of trading goods in local currency instead of adjust the price according to the exchange rate. The international evidence shows that the pricing to market behavior and exchange-rate pass through is often interpreted as consistent with “local currency price stability”. This kind of price discrimination behavior does not only affect the price of traded goods, but also influences various kinds of price rigidities. (Alexius and Vredin,1999)

Pick and Cater(1994) explain that the reasons for PTM behaviors. Firms prefer to keep stable prices in foreign markets that have fluctuating exchange rates may exercise this preference by exerting market power. It may result from the demand elasticity: As the importing country’s currency appreciates, the import price falls and demand increases. However, when the exporter does not have the ability to adjust the raised demand for its goods, the extend of currency appreciation will not completely reflect in the price of trading commodities. In addition, there is also implication that shocks to national market conditions, such as exogenous changes in the exchange rate, can generate deviations between the prices that firms charge in each market. ( Bergin,2003) At last, PTM may simply because that exporting firm want to keep competitive: many firms in these countries are said to have followed pricing policies designed to keep export prices competitive despite changes in exchange rates.(Marston,1990)

Literatures about PTM are generally based on models. In pricing to market modelsfrom the work of Betts and Devereux(1996), they adapt a model that firms produce different products to export to different countries, besides, firms can set different exporting prices for different destinations. They learn from the result of the model that the increase in the fluctuation of exchange rate arising from PTM may be very large by doing a simple quantitative exercise based on the estimated degree of PTM in international trade. That’s to say, when firms engage in PTM, when a country face with money shocks, the effects of this shocks are quite different compare with the traditional exchange rate models in which prices are set in the currency of the exporter. What’s more, PTM plays a central role in exchange rate determination and in international macroeconomic fluctuations. It acts to limit the pass-through from exchange rate changes to prices, and reduces the traditional ‘‘expenditure switching’’ role o exchange rate changes. (Betts and Deuereux,2000)

Implications of PTM for PPP

A direct implication of the PTM hypothesis is the low pass-through from the exchange rate to prices, and the resultant failure of the relative PPP to hold in the short and intermediate-runs.(Aizenman,2004) PPP(purchasing power parity) is a conception widely used in international economy. The basic idea about PPP is when consumers purchase identical products in any market worldwide, the quantity of money should be the same when measured in one currency (Hallwood and MacDonald, 2000). Applied to aggregate price data, purchasing power parity is the hypothesis that the import prices that of one country to purchase another country’s goods should move one-for-one with the producer prices for goods in those countries that are the sources of those imports when all of these prices are expressed in a common currency. (Atkeson and Burstein,2008)

When firms and producers applied PTM, many aspect of the country’s economy will different from the PPP holders. From the analysis of model in Betts and Deuereux(2000),the implications of PTM to PPP can be conclude as follows:

The most obvious implication of PTM is the price volatility. Actually, if there is no price rigidity, the law-of one- price would be available for all kinds of products, and PPP would hold generally, even though there is still exist some extend of international market segmentation. However, if sticky local-currency prices hold, changes in the exchange rate will result in deviations from the law-of-one-price. While when complete PTM applied, the exchange rate will play a different role in the LOOP environment, relative prices of importer and exporters will not be affected by the fluctuation of exchange rate. but it has an impact on relative incomes. If export prices are set in foreign currency, when a depreciation happened in this currency. The home currency earnings of home firms will increase, at the same time, foreign firms’ foreign currency earnings will decrease at given production levels. Thus a depreciation generates a world redistribution of income towards the home country, which raises home consumption relative to foreign consumption. This occurs without the influence of relative price changes. (Betts and Deuereux,2000)

PTM have a positive effect on promoting the real exchange rate movements: the larger of the PTM sector is, the lower effect of a money shock will the country get. Say a country faced with a money shock which will result in a depreciation of the currency, if PTM holds in a large sector, the impact on reallocation of spending away from domestic goods consumption towards foreign goods will be reduce to a large extend. The reason for this maybe the exchange rate is response to depreciation, however, this kind of currency price change would not affect the domestic market. PTM acts to limit the pass-through from exchange rate changes to prices, and reduces the traditional ‘‘expenditure switching’’ role of exchange rate changes. Nominal price stickiness associated with PTM magnifies the response of the exchange rate to shocks to fundamentals. (Betts and Deuereux,1996) The effect of monetary policies varies from cooperative firms and non-cooperative firms: at first, this need to be confirm that there is always a gain from coopperation, and secondly, that the gain reaches a maximum at the polar cases of no and full pricing to market since in these cases the movement in the terms of trade and thus the welfare spill-over is at a maximum in the non-cooperative setting. (Michaelis,2006)

Empirical evidence of PTM

As a common strategy of international firms, PTM behavior are widely used all over the world. By investigating data from those firms, we can get the empirical effect of pricing to market. Gil-Pareja(2002) investigated PTM behavior in European car markets during 1993 and 1998. He found that local currency price stability is a strong and pervasive phenomenon across products independent of the invoicing currency. In fact, there are large gaps among the automobile retail prices across EU Member States since the early 1980s, which is deviated from the law-of-one-price. (Gil-Paraja,2002) After analyze and compare the data of different EU countries, it can be easily conclude that the strategy tries to avoid the effect of changes in exchange rate changes is just in order to make the profits across segmented markets be maxime. Exporting firm will get the highest expected profits under exchange rate uncertainty by setting price of the importer’s currency.

Since early 1980s, Japanese yen has experienced a depreciation. Marston(1990) has investigated pricing to market by Japanese firms from 1980 to 1987. He explores how Japanese firms responded to shifts in the real exchange rate by varying the prices of their exports relative to prices of products destined for the domestic market. The estimation distinguishes between inadvertent but temporary changes in these margins due to exchange rate surprises and planned changes associated with PTM behavior; He found there is overwhelming evidence that export-domestic price margins are systematically varied to help Japanese firms protect their competitive position. (Marston,1990) According to the exporter in UK, how is export pricing affected by other firm specific or contextual environmental variables such as export experience of the firm, degree of export development, type and intensity of market competition among others. The extend of PTM is based on variable of elements such as the industry level, the information and the like.( Tzokas et al.,2000)

Conclusion:

Pricing to market make the price of international trading goods free from the fluctuation of exchange rate, as a result, PPP no longer hold in those countries which applied PTM. Theories, as well as empirical evidence suggest that PTM has a strong implication of consumption and welfare distribution. It is a effective way for international co operations to avoid the negative influence of exchange rate fluctuation. But the extend of PTM is varias among different counties and industries.

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