Exchange rates, market structure and price-cost margins: evidence from a developing country

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1 Applied Economics, 2002, 34, 783±789 Exchange rates, market structure and price-cost margins: evidence from a developing country OÈ N ER GUÈ N CË AVDI and BEN AN ZEK _I ORBAY * Istanbul Technical University, Faculty of Management, and Technology and Economic Development Research Centre (TEDRC), Macka, Istanbul, Turkey This paper analyses the sensitivity of rm performance to exchange rate uctuations. In a two-country world, consisting of a developing domestic country and a developed foreign country, we show that this sensitivity is closely related with market structure and the share of imported inputs in total cost. When the share of imported inputs is low, depreciation leads to an increase in price cost margin. This increase intensi es in more competitive industries. When the imported input share is high, the price cost margin may decrease as a result of depreciation, and this evect becomes pronounced in more competitive industries. The empirical test where we used 3-digit Turkish Manufacturing industry data support most of the ndings of our model. I. INTROD UCTIO N Exchange rates have changed sharply during the 1980s in many countries. Developing countries experienced these changes even more pronouncedly together with the liberalization of foreign trade. Looser trade restrictions have led to a sharp rise in import competition in many developing countries. The pro tability of the rms in concentrated markets was inevitably avected by these changes. In the last few years, there has been increasing interest in the extent to which movements in exchange rates have been passed through to domestic prices. This line of research was initially undertaken for industrial countries (Fienberg, 1986, 1989), but recently such researches have also been carried out for developing countries (Lee, 1997; Yang, 1997). However, a few studies consider the in uence of movements in exchange rates on rms pro tability in parallel with an analysis of the role of foreign trade in a structure-performanc e framework (Katrak, 1980). This paper examines this relationship with respect to the Turkish manufacturin g industry, and seeks empirical evidence on the role of industry speci c factors, such as the high dependence of imported inputs, in this relationship. An earlier paper by Dornbush (1987) theoretically showed that the sensitivity of domestic prices to exchange rates depends on the relative number of rms in trading countries, market structure and product substitutability, but did not incorporate the in uence of some features of domestic developing countries, such as high dependence on imported inputs in domestic production. The theoretical model employed in this paper, however, includes this feature of a developing country. A two-country world is considered, developed and developing ones, and rms in these countries compete aá la Cournot. The novelty of the present paper is that the production technology in the developing country is assumed to be less e cient, and requires high use of imported inputs. Theoretical results postulate that the share of imported inputs is an important determinant of price-cost margin (pcm), and the responsiveness of the pcm to movements in exchange rate is in uenced not only by the factors such as market structure, but also by the use of imported inputs in domestic production. The paper is organized as follows. The next section describes the theoretical model, and introduces the hypothesis to be tested. Section III presents the empirical testing * Corresponding author. benan@ayasofya.isl.itu.edu.tr Applied Economics ISSN 0003±6846 print/issn 1466±4283 online # 2002 Taylor & Francis Ltd DOI: /

2 784 O. G unc avdõ and B. Z. Orbay using the past 15 years of the data (1982±1993) for the 3- digit Turkish manufacturing industry panel data. The last section concludes. II. THE THEORETICA L MO DEL In this section, a simple theoretical model is considered examining the relationship between the performance of rms, the domestic market structure, foreign trade and movements in exchange rates. The theoretical model is built upon Dornbusch s (1987) Cournot model. In a twocountry world (namely a developing home country and a developed foreign country), the model assumes that there are n rms for a given industry in the developing domestic country, and n rms in the developed foreign one. Unlike Dornbusch (1987), it is assumed that the domestic country is a developing one with relatively ine cient production technologies and high import dependence in production. For simplicity, it is assumed that there is no transportatio n costs. On the supply side of the model, a typical rm i in the domestic country possesses a Cobb-Douglas production technology with constant-returns-to-scale, and uses domestic, k i, and imported, k i, inputs in production: x i k i ; k i ˆ k i 1 s k i s ; i ˆ 1;... ; n 1 where x i is the output level of the ith rm, and s is the share of imported inputs in total cost. Using the production function in Equation 1, the indirect cost function accruing to the domestic rm can be written as: c i r; r ; e; x i ; x i ˆ Ar 1 s er s x i x i ; where A ˆ 1 s =s s where x i and x i are the levels of output produced for the domestic and the foreign markets, e is the exchange rate, and r and r are the unit costs of domestic and foreign inputs, respectively. The rms in the foreign country are assumed to use only domestic inputs, and the cost function of the foreign rm i can be as follows: 2 c i y i ; y i ˆ c y i y i ; i ˆ 1;... ; n 3 where y i and y i are the levels of outputs for the home market and developing country s market, respectively. It is assumed that foreign rms possess cost advantages over domestic ones mainly because they operate with more e cient technology and lower input prices. This assumption implies that foreign rms unit cost of production is lower than the unit cost of domestic rms, i.e. ec < Ar 1 s er s. Hence, it is expected that the import competition is more intense in the developing country s market. On the demand side of the model, linear demand functions for rms in both countries are assumed, respectively: p x ˆ a bx; a; b > 0 p y ˆ a b y ; a ; b > 0 4a 4b where x ˆ Pn iˆ1 x i P n iˆ1 y i and y ˆ Pn iˆ1 x i P n iˆ1 y i. Firms in both countries are assumed to compete aá la Cournot. In order to derive equilibrium conditions the following pro t functions can easily be derived by using Equations 2, 3 and 4: º i ˆ p x x i ep y x i c i r; r ; e; x i ; x i ; i ˆ 1;... ; n 5a º i ˆ p x y i ep y y i ec i y i ; y i ; i ˆ 1;... ; n 5b where p i and p i represent the pro ts of domestic and foreign rms respectively. First, rst-order conditions are derived taking the derivatives of Equation 5a with respect to x i and x i and Equation 5b with respect to y i and y i. Then the reaction functions of domestic and foreign rms obtained from the rst-order conditions are simultaneously solved to reach the following equilibrium levels of outputs: x i ˆ a Ar 1 s er s 1 n ec n bn x i ˆ ea Ar 1 s er s 1 n ec n eb N y i ˆ ea ec n Ar 1 s er s n eb N y i ˆ a ec 1 n Ar 1 s er s n bn 6a 6b where N ˆ 1 n n. Substituting Equation 6 into Equation 4, the equilibrium prices of the domestic and foreign markets, respectively, can be derived as follows: p ˆ a Ar1 s er s n ec n N p ˆ ea Ar 1 s er s n ec n en 7a 7b Having derived equilibrium price functions in Equation 7, it is possible to examine how movements in the exchange rate in uence prices and the price-cost margins of rms in the developing country. For this purpose, the following price elasticity with respect to the exchange rate can be computed from Equation 7: ² ˆ n ec N p n sar 1 s er s N p Equation 8 indicates that movements in the exchange rate in uence the domestic prices through the production costs 8

3 Evidence from a developing country 785 of foreign and domestic rms. The rst term on the righthand side of Equation 8 represents the pass-through evect through the production cost of the foreign rms, and it can be decomposed into two separate evects, namely, n =N and ec =p. As indicated in Dornbusch (1987), the former measures the ratio of imports in total sales 1 whereas the latter shows the degree of competition for the foreign rms. In the case of high share of imports in total sales, it is seen from the rst term that the pass-through evect arising from the production cost of foreign rms becomes more pronounced. Due to the evects of the latter term, it is possible to note that when the market becomes more competitive, the extent of the exchange rate pass-through evect also magni es. Unlike Dornbusch (1987), there is an additional term on the right-hand side of Equation 8, which shows the passthrough evect resulting from the production cost of domestic rms. This additional term appears in Equation 8 due to the dependence of the domestic rms on imported inputs in production. Similar to the rst term on the right-hand side of Equation 8, this second term can also be decomposed into two separate components, namely n=n and sar 1 s er s = p. The former component shows the share of domestic output in total sales whereas the latter shows the degree of competition for domestic rms. It is expected from Equation 8 that the evect of pass-through arising from the cost of domestic rms becomes more pronounced when the share of domestic output in total sales and share of imported inputs in total cost, s, are higher. This passthrough evect also magni es in the case where the market is more competitive. One of our main purposes in this study is to analyse the sensitivity of the price-cost margin pcm of domestic rms to exchange rate uctuations, and theoretically examines the main factors evecting this sensitivity. Under the constant-returns-to-scal e assumption, the pcm of the domestic rm i can be obtained for domestic and foreign markets, respectively, as follows: pcm d ˆ p Ar 1 s er s p ˆ a Ar 1 s er s 1 n ec n a Ar 1 s er s n ec n pcm f ˆ p Ar 1 s er s p ˆ ea Ar 1 s er s 1 n ec n ea Ar 1 s er s n ec n 10a 10b Responsiveness of pcms to movements in exchange rate can easily be seen from Equation 10a and Equation 10b. The exchange rate elasticities of pcms of domestic rms for domestic and foreign markets respectively are: " d ˆ d pcm d de e pcm d ˆ ~c ec n 1 s sa p a c 1 n ec n 5 0 " f ˆ d pcm f de e pcm f ˆ ~c p a c n 1 s ea c 1 n ec n 5 0 if ec n 1 s 5 sa 11a 11b where ~c ˆ Ar 1 s er s is the unit cost of domestic rms. As seen from Equation 11, pcm is always increasing with the exchange rate in the foreign market; however, it increases with e in the domestic market only when s is small. From Equation 11a, it is seen that " d always decreases with s, and even becomes negative for su ciently large values of s. This result supports the view that an increase in the cost of domestic rms due to depreciation in domestic currency is high in the case of high s and, this causes domestic pcm to decrease. This evect is not observed on the pcm obtained in the foreign market because depreciation also increases the revenue obtained in the foreign market in terms of home currency. Unfortunately in the case of high s, we are unable to examine the net evect of the change in domestic currency on the pcm of the domestic rms. This is because depreciation also increases the revenue obtained in the foreign market in terms of home currency. Therefore, it is only possible to say that the net evect on pcm of depreciation in domestic currency increases with e in the case of low s, but may decrease with e for the high levels of s. Let us now analyse the evect of degree of competition on the elasticity of pcm with respect to exchange rate. It is observed from Equations 11a and 11b that the decrease in the mark-up ratio p=~c (i.e. increase in competition) magni es the sensitivity of the pcm to exchange rates. In other words, the movements of exchange rates create more pronounced evects on both domestic and foreign pcm in more competitive markets. However, the direction of the overall evect will be in uenced by the extent of the cost of imported inputs in total production cost. When the share of imported input costs is low, it is expected that the exchange rate elasticity of the pcm always increases with the increase in the degree of competition. For the high share of imported inputs, this elasticity may both increase and decrease with more competition. Two factors operating in opposite directions cause this inconclusive result. 1 In Dornbusch (1987), due to the equal initial wages assumption, n =N is an exact measure of imports in total sales. In our framework, cost of inputs is initially diverent between two countries, but this measure is still proportional with the ratio of imports to total sales.

4 786 O. G unc avdõ and B. Z. Orbay When the imported inputs cost share is high, the domestic pcm is negatively related with exchange rate, and this inverse relationship becomes even more pronounced with increasing competition. This is because depreciation in domestic currency creates a loss in the domestic pcm, and more competition magni es this loss. The elasticity of the pcm in the foreign market is, on the other hand, always positively related with e, and more competition magni es this positive relationship. In sum, it can be observed a negative relationship between pcm and e in the case of high share of imported input cost, which may be intensi ed with more competition. The evects of the cost of foreign rms on the exchange rate elasticity of the pcm of domestic rms can also be seen from Equations 11a and 11b. As it is intuitively expected, an increase in the cost of foreign rms will decrease the sensitivity of pcm to changes in exchange rates. This increase in the cost of foreign rms can be interpreted as a decrease in the intensity of competition for the domestic rms. Hence, its evects on the exchange rate elasticity of pcm become consistent with the case of a decrease in the intensity of competition. According to these theoretical ndings the following hypotheses will be tested in the following section with Turkish Manufacturing Industry data: H1a: A depreciation of the Turkish Lira against US dollar should increase the pcm if the share of imported inputs in total cost is low. H1b: A depreciation of the Turkish Lira against US dollar may decrease the pcm if the share of imported inputs in total cost is high. H2a: The increase in the pcm as a result of a depreciation of the Turkish Lira intensi es in more competitive domestic industries if the share of imported inputs in total cost is low. H2b: The increase or the decrease of the pcm as a result of a depreciation of the Turkish Lira may intensify in more competitive domestic industries if the share of imported inputs in total cost is high. II I. AN EM PIRICA L A NALYSIS As seen in section II, an important source of transmission of international shocks may be through the use of imported inputs in production in developing countries. The theoretical model postulates that the sensitivity of the pcm to movements in the exchange rate varies according to the magnitudes of the share of imported inputs in production. The response of the pcm to the real exchange rate, for example, is positive in the case of the low share of imported inputs in production; it may, however, be negative when the share of imported inputs is high. This is also the case for the evects of other variables postulated in the hypothesis given in section II. Import dependence in production is evident particularly in developing countries. Likewise, empirical research for Turkey consistently shows that most of the industries in Turkish manufacturin g sector are heavily dependent on imported inputs (Senesen and KucukcË iftci, 1991). Having presented theoretical discussion above, this section lays emphasis upon empirical testing of the link between movements in foreign exchange (EXCH) and the price cost margin (PCM). Our aim is also to analyse the importance of the industry-speci c factors that may in uence the pass-through mechanism between EXCH and PCM. Before turning to the empirical testing, it must be noted the limitation of the data in the sample. Following the discussion above, it is necessary for testing the role of imported inputs in production to have a disaggregate data on the composition of inputs used in production. However, the data from the annual surveys of manufacturing industry in Turkey contains no information on imported material inputs at such a disaggregation level. The lack of continuous data for the 1983±1993 period on imported inputs in each industry lead us to make a simple but more or less consistent assumption with Turkish economy that the industries in manufacturing sector is dependent very much on imported materials, and it is assumed that the share of the imported inputs in production is high. With this assumption, therefore, the expected evects of the real exchange rate and industry speci c variables will be in accordance with the high share case of imported inputs. Following the theoretical model in the previous section, special attention is paid to some industry speci c factors such as market structure HI, the import share of the domestic consumption M, the export share of the total output X, and the production cost of the foreign competitor W. The aim is to see how the sensitivity of the pass-through mechanism is avected by these factors, using the past 14 years of the data (1983±1996) for each of 28 Turkish manufacturing industries, de ned at the 3-digit ISIC level. Although the data is available for the period of 1982±1996, the sample period in the empirical investigation corresponds to the liberalized exchange rate period starting from The Her ndahl Index, calculated by GuÈ nesë (1998), is chosen as a proxy variable to capture the evects of market structure. A measure of four- rm seller concentration ratio is also reported in GuÈ nesë (1998), but its correlation with the Her ndahl Index is almost 0.97 (see Table 2). The real exchange rate used in the empirical investigation is measured by the index of the trade weighted real evective exchange rate of two important trade partners of Turkey, namely the USA and Germany. In order to capture the evects of general macroeconomic conditions, gross domestic product (GDP), which may proxy to some extent the demand condition in the economy, is included in the

5 Evidence from a developing country 787 Table 1. The de nition of variables Variables PCM it EXCH t HI it (Value added ± total wage payments)/value added for 3-digit ISIC industry i, year t, taken from various Annual Manufacturing Industry Statistics. Source: State Institute of Statistics (SIS). Trade weighted evective real exchange rate index, calculated from currency baskets consisting of US Dollar and German Mark. The weights in the basket for both currencies diver between the periods of 1982±1986 and of 1987±1993. The weights for the former period are 0.5 for US Dollar and 0.5 for German Mark whereas they are 0.75 for US Dollar and 0.25 for German Mark in the second period. Source: The Quarterly Bulletin of the Central Bank of Turkey. The Her ndahl Index (sum of squared market shares) for industry i, year t is used to measure the market structure in each sector. Source: GuÈ nesë, M. (1998) TuÈrk Imalat Sanayinde Yogunlasma Oranlarini Belirleyen FaktoÈrler 1980±1994, State Institute of Statistics, Ankara. M it The values of imports as a percentage of domestic consumption for industry i, year t ± the import penetration ratio ± M= D M X, where M ˆ imports, D ˆ domestic outputs, X ˆ exports. Sources: State Institute of Statistics (SIS) X it W it The value of export as a percentage of total output for industry i, year t ± the export penetration ratio ± X=D. Sources: State Institute of Statistics (SIS). Trade weighted unit labour cost as a proxy for a foreign cost measure. The labour cost is taken for 3-digit ISIC industries from the USA and Germany, two major trade partners for Turkey in terms of origins of imports. Sources: ILO Yearbooks of Labour Statistics. GDP t Real gross domestic product (1987 ˆ 100). Source: State Planning Organization (1997), Ekonomik ve Sosyal GoÈ stergeler (1950± 1997). estimation procedure. As the formulation of the PCM is open to some debate (see Canyon and Machin, 1991), the ratio of `value added minus total wage payments to value added is used (see Hart and Morgan, 1977). The cost of the production of the foreign competitor is proxied by the average unit wage cost variable. Provided that the USA and Germany are two major trade partner of Turkey, 2 the average labour cost is used for 3-digit ISIC industries of the USA and Germany weighted by the share of these two countries in Turkey s total imports. The de nitions and the sources of all variables are given in Table 1, and a correlation matrix in Table 2. The theoretical model in section II postulates that the sensitivity of exchange rate pass-through is in uenced by some industry speci c factors. It is explicitly shown that the market concentration is in uential on the pcm. However, literature also suggests that the export and import penetration ratios might be important determinants (see Feinberg, 1986, 1989). Although the theoretical model is unable to shed enough light upon the signs of the import and export penetration ratios (mainly because of the complexity of Equation 11), it is possible to predict them. The following regression equations in this respect are estimated on 336 pooled cross-section/time series observations i ˆ 1;... ; 28; t ˆ 1982;... ; 1996) using the least-squareswith dummy variables approach: Table 2. Correlation matrix pcm gdp exch hi cr4 m x gdp Ð Ð Ð Ð Ð Ð exch Ð Ð Ð Ð Ð hi Ð Ð Ð Ð cr Ð Ð m Ð Ð x Ð Ð w Note: All small case variables are in logarithms pcm ti ˆ a 01 a 1 gdp t a 2 exch t pcm ti ˆ a 0 a 1 gdp t a 2 exch t a 3 m ti exch t 13 a 4 x ti exch t a 5 h ti exch t a 6 w ti exch t 14 where small cases show the logarithm of relevant variables. The movement of the macroeconomic condition is captured by the coe cient of gdp, which is kept constant across industries due to insu cient number of observations. The evects of exchange rate pass-through on to the pcm are measured by the coe cient a 2 in Equations 1 and 2. The signs of the coe cients are expected as follows: a 2 < 0; a 5 > 0. In industries that depend heavily on the 2 The origins of almost 25±30% of Turkey s imports are Germany and the USA. The rest of the imports are provided from the great variety of countries.

6 788 O. G unc avdõ and B. Z. Orbay Table 3. LSDV estimation results (dependent variable pcm ti ) (i) (ii) (iii) (iv) (v) gdp t (7.062)** (7.333)** (3.074)** (7.342)** (7.269)** exch t ( )** ( )** (79.164)** ( )** ( )** h it Ð Ð Ð Ð (3.041)** m it Ð Ð Ð Ð (71.046) x it Ð Ð Ð Ð (1.784)* m ti exch t Ð Ð Ð (70.957) (71.024) x ti exch t Ð Ð (1.747)* (1.821)* (1.611) h ti exch t Ð Ð (3.158)** (3.137)** (3.175)** w ti exch t Ð Ð Ð Ð (70.773) R 2 -adj SD d:f : F (29.306) (32.303) (33.302) (32.303) (31.304) Note: ** and * indicate the signi cance level of all relevant variable at 5 and 10% level respectively. imports of raw materials, changes in the real exchange rate are expected to have a negative evect on the pcm. For example, real devaluation s (in other words increase in the value of the real exchange rate) cause the industry to encounter a negative shock due to an increase in the cost of importation; a 2 < 0 (see H1b in section II). Intuitively it is expected that the sign of the import penetration ratio, m, is negative whereas the export penetration ratio, x, is positive. The market structure avects the responsiveness of the pass-through mechanism in such a way that the more competition (meaning lower value of Her ndahl index) may make the pcm of industries more sensitive to movements in real exchange rate; therefore, we may expect that a 5 > 0 when a 2 < 0 (see H2b in section II). Equations 13 and 14 also include a set of industry intercept and slope dummy variables. F tests rejected at the 1% signi cance level the hypothesis that all of these slope and intercept dummies had a value of zero (Statistics is ). In the second equation, the diverences across industries are xed, and are modelled using dummy variables for each industry. From Equation 14, the elasticity of the pcm for industry j to the real exchange rate is derived as a function of industry speci c variables as follows: h ˆ dpcm ti =dexch t ˆ a 2 a 3 m ti a 4 x ti a 5 h ti a 7 w ti 15 Equation 15 indicates that the evects of pass-through vary over time and across industries. Table 3 indicates the major determinants of variation in the pcm using the least-square dummy variable approach. The estimated models possess a good explanatory power, indicating that explanatory and dummy variables for industries in the model explain 76% of total variation in the pcm. The signs of all coe cients are in accordance with our theoretical expectations, and majority of them statistically signi cant. According to estimated models (i)±(v), the real value of Turkish Lira (TL) is one of the determinants of movements in the pcm in Turkey, and highly signi cant in all speci cations. The sign of the exchange rate variable is negative, implying that an increase in the real value of the TL decreases the pcm. This result is particularly consistent with the case where the industries are heavily dependent on imported inputs and highly sensitive to the real depreciation of TL through the cost of production. The results of model (ii) implies that the pcm is also in uenced by some industry speci c factors such as the concentration ratio, the import and export penetration ratios. In addition to high R 2 of the model ± which is improved little after including industry speci c variables ± all variables come out very and signi cant according to their t-statistics with the only exception of the estimated coe cient of the import penetration ratio.

7 Evidence from a developing country 789 However, the question that stands is whether the responsiveness of the pcm with respect to movements in the real exchange rate varies with sector speci c factors. Returning to our principal model (Equation 14) as reported in Equations (iii)±(v) in Table 3, a major determinants of the responsiveness of the pcm to the exchange rate passthrough are the market concentration ± signi cant at the 5% signi cance level with a coe cient 0.02 in model (v) ± and export penetration ratios ± signi cant only at 10% signi cance level with a coe cient 0.3E-4. The t-ratios of pass-through mechanism in uenced by the import penetration ratio and the foreign cost variable in estimated models (iii) and (iv), on the other hand, appear to be insigni cant at any signi cance level. Having excluded these insigni cant variables, new results in Equation (v) show that the market concentration and the export penetration ratios keep their importance with a decline in the t-statistics. IV. CONCLUS ION The aim of this paper is twofold. The rst one is to examine theoretically the evects of including the use of imported inputs in production on the exchange rate pass-through mechanism. The second is to analyse empirically the signi cance of variations in exchange rate in the determination of the pcm, and to investigate how some industryspeci c factors in uence the responsiveness of the pcm to changes in the exchange rate. For this purpose, a theoretical model has been built upon Dornbusch (1987) by including the use of imported inputs in production. It is estimated that the exchange rate elasticity of the pcm for the past 11 years (1983±1993) for each of 28 Turkish manufacturing industries, de ned 3-digit ISIC. The results suggest that variations in the value of Turkish Lira against foreign currencies can be considered as a factor avecting the pcm in the Turkish manufacturing sectors. According to empirical ndings of the paper, this pass-through mechanism is in uenced by some industry-speci c factors, such as market structure and the extent of export penetration. It is not possible to test empirically to what extent the dependence on the use of imported inputs in production is important in the exchange rate pass-through mechanism because of the lack of appropriate data. However, the empirical results without including this variable have appeared to be consistent with the expectation of the case where the share of imported inputs in production is high. ACK NOW LED GEMEN TS The authors are grateful to BurcË UÈ lengin, UÈ mit S enesen, Ertug rul Tokdemir, Raziye Selim and Suat Ku«çu«kçiftçi for helpful comments and fruitful discussions. 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