Pricing-to-Market and Its implications for PPP

Introduction

At present, with the increasing process of globalization, the world is integrated as a huge market. International trade is becoming increasingly important between countries. Therefore, exchange rate are now of great concern, people care about its ups and downs, and its implications, especially, to what extent will the exchange rate change influence the price of imported or exported goods. It is important to introduce the idea of PTM to understand this question. The article will first introduce the concept of pricing to market, and then introduce the implications of pricing to market for purchasing power parity. Finally, I will give the conclusion.

Review of PTM

PTM is considered to be a phenomenon, and this happens in international trade between countries. When the market is in division and there is no “hot money”, exporters could set different prices according to the places importing from them; they could choose either producer currency pricing or local currency pricing. When producer currency is used, devaluation reduces export price of local commodities, change in exchange rate has conducting effect to price, therefore guarantees the effectiveness of one price law and purchasing power parity; however when local currency pricing is chosen, devaluations of producer currency does not affect export price of commodities since they are priced in local currency. International trade cost is essential in pricing to market.

Atkeson and A.Burstein(2008) stated that without international trade costs, even in the presence of variable markups that lead to incomplete pass-through, we have no pricing-to-market. Hence, imperfect competition with variable markups is necessary, but not sufficient, for pricing-to-market.

It is widely believed that PTM does not apply to all categories of goods, that it , the extent of Pricing to market varies in different goods trade. Krugman.P(1987) stated that:” PTM is not universal, pricing to market seems to be limited to the transportation equipment and machinery industries” according to his research on US and Germany.

In short, PTM refers to the action of a firm to set different price of the same product in different markets.

Implications of PTM for PPP and empirical evince on that

1. PPP was first formally introduced by Gustav Cassell in 1920, it was aimed to provide a standard for currencies to slove the problem of compensations after the first world war. It indicates that 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). At present time, PPP has two functions in economics: one, to judge a currency has whether been over or under estimated, second, as a tool of conversion, to convert GDP or GNP of one country from its own currency into another, therefore compare the economic strength between them.

PPP has now been developed into two forms, the absolute ppp and relative ppp. Absolute ppp is based on the law of one price, the theory of absolute purchasing power parity states that the same basket of goods should sell for the same price everywhere (Alessandria,G&Kaboski,P,K, 2009), while relative ppp debates that exchange rates can be adjusted according to the inflation differentials existing in two markets (Pilbeam, 2006).

Unquestionably, the implication of PTM for purchasing power parity is influential according to many researches and studies done. PTM weaken the influence of PPP. The theory of PPP indicates that significant change in exchange rate should result in the devaluation of national inflation and appreciation of national deflation. But the truth is that, either the ups or downs of exchange rate did not significantly affect the inflation. One reason why exchange rate is such insignificant is obvious: exchange rate does not affect volume of trade and total price, as what people expected. The reason lies here is PTM, producers exporting commodities to other countries did not change exporting prices as people expected. For instance, when Japanese producer exporting automobiles into American market, they will set their products’ dollar price on the basis of specific situations in American market. If yen was in an appreciation, they would, by and large, reduce the yen price but not raise the dollar price to maintain its current business scale in American market. They would rather to eliminate the effects caused by change of exchange rate by adjustments within the enterprise itself. In such condition, exchange rate could not play the important role as it should have played.

Betts,C and Devereux M,B (1998) argued that: “PTM plays a central role in exchange rate determination and in international macroeconomic fluctuations.” The pass-through from exchange rate changes to prices is strongly restricted by actions of PTM. They also stated that: “PTM generates departures from purchasing power parity; it tends to reduce the comovement in consumption across countries, while increasing the comovement of output.” (Betts,C and Devereux M,B ,1998). Generally, according to theory of one price and purchasing power parity, changes in exchange rate would pass through efficiently to prices, that prices will be adjusted until it fits the changes in exchange rate, and there will finally be equilibrium. But PTM, as personal actions of enterprises, to some extent, obstructs the channel of passing through. In the conditions of high PTM extent, devaluation of exchange rate has a very limited impaction on the prices determination of imported commodities, as (Betts,C and Devereux M,B ,1998) stressed:”the allocative effects of exchange rate changes are therefore wakened.”

PTM also has important welfare implications for the transmission of monetary policy shocks. (Betts,C and Devereux M,B ,1998). In a situation under PPP, an unexpected expansion of monetary policy will result in increase in welfare of all organization, no matter home ones or foreign ones. Betts,C and Devereux M,B ,(1998) concluded that: “Monetary policy is a ‘beggar- thy-neighbor’ instrument in the presence of PTM”.

2. The phenomenon of pricing to market is everywhere in our daily life, and it significantly weaken the influence of law of one price and theory of purchasing power parity, tells people the truth that the same amount of currency could not always buy same basket of goods in different countries’ market.

Since the same product could be priced differently in two countries, there will be space of arbitrage. I found exactly the same mode of DELL laptop both sold in U.S and China, on EBay, this dell allienware m15x is priced $1449.99, on the official site of dell china, it is priced 16999 RMB, according to the present exchange rate of RMB over US dollar: 6.573, 16999RMB is $2586, it is $1086 more that in US. Obviously, the transportation cost to bring one laptop from US to China is far more less than $1086. It can be implied that many people will try smuggling commodities like this laptop to earn profits.

Conclusion

As above discussion, PTM is important in the determination of exchange rate, higher the PTM is, less influence will the exchange rate change make on prices. It also makes significant welfare implications for the transmission of monetary policy shocks. PTM and its implication on PPP is still necessary to be further researched.

Reference

1. Krugman, P. (1986), “Pricing to Markets when exchange rate changes”, In: Arndt, S.W., Richardson,J.D. (Eds.), Real-Financial Linkages among Open Economies. MIT Press, Cambridge.
2. Mark, N. C. (2001), International macroeconomics and finance: theory and econometric methods, Wiley-Blackwell.
3. Sarno, L. & Taylor, M.P. (2002), “new open-economy of macroeconomics”. In The economics of exchange rate, Cambridge University Press, Cambridge,
4. Hallwood, P. and MacDonald, R. (2000) International Money and Finance, 3rd ed.Blackwell.
5. Pilbeam, K . (2006) International Finance, 3rd ed. MacMillan.
6. Atkeson,A & Burstein,A (2008) “Pricing-to-market, Trade cost, and International Relative Price*”. University of California, Los Angeles and Federal Reserve Bank of Minneapolis
7. Alessandria,G&Kaboski,P,K (2009) “Pricing-to-Market and the Failure of Absolute PPP”
8. Betts,C and Devereux M,B (1998), “Exchange rate dynamics in a model of pricing-to-market” in Journal of International Economics 50 (2000) 215–244
9. alienware m15x items- get great deals on PC Laptop notebooks,alienware m17x items on eBay.com! (2011). Retrieved March 9, 2011 from http://shop.ebay.com/i.html?_nkw=alienware+m15x&_frs=1&_trksid=p3286.c0.m359
10.  Dell (2011). Retrieved March 9, 2011 from http://www1.ap.dell.com/content/topics/topic.aspx/ap/topics/microsite/zh/odg_campaign c=cn&cs=cndhs1&l=zh&s=dhs&~ck=mn