The Dynamics of Trade and Competition

1. The Dynamics of Trade and Competition Natalie Chen (Warwick & CEPR) Jean Imbs (Lausanne & CEPR) Andrew Scott (London Business School & CEPR)

2. 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

3. You can see why….

4. 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….

5. 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

6. 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

7. What this paper does 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

8. 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.

9. Plan • Theory • Estimation Strategy • Data (markups) • Main Results

10. Plan • Theory • Estimation Strategy • Data (markups) • Main Results

11. Theory Objectives: Introduce theoretical channels between prices, productivity and mark ups Motivate 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)]

12. 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).

13. 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.

14. 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

15. 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,

16. 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.

17. 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

18. 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.

19. 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:

20. 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.

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

22. Plan • Theory • Estimation Strategy • Data (markups) • Main Results

23. Openness Introduce import share θ We have By symmetry Useful to rewrite:

24. From Theory to Estimation Prices Markups Productivity

25. Econometrics Issues • Intercepts • Estimation 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:

26. Instruments for import shares • Ratio of imports weights to their value, across countries, sectors and over time. • 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.

27. Plan • Theory • Estimation Strategy • Data (markups) • Main Results

28. 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

31. Plan • Theory • Estimation Strategy • Data (markups) • Main Results

36. 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.

37. Robustness Nominal Exchange Rates Factor Endowments GMM estimators Benchmark (Italy) as a treatment effect Origin of Imports

38. 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

39. 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

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