Inflation Dynamics’ Micro Foundations: How Important is Imperfect Competition Really?

1. Inflation Dynamics’ Micro Foundations: How Important is Imperfect Competition Really? Sara G. Castellanos and José A. Murillo Banco de México September 2004

2. The TRUE Motivation Why we are not inside those bands yet? One possibility is that prices in less than perfectly competitive sectors (e.g. tobacco, gas, pharmaceutics, movie theaters, bread, air transportation, etc.) be deflating more slowly than others.

3. Motivation On one hand: • Macroeconomic models increasingly rely on imperfect competition to explain monetary policy’s effectiveness, staggered prices, and inflation inertia (Blanchard and Fischer, 1989; Calvo, 1983, Mankiw, 2000). • Calibrations of this type of GE models reproduce well the dynamics of United States’ business cycle (Chari, Kehoe and McGrattan, 2000; Christiano, Eichenbaum and Evans, 2001). • Merits of different stabilization strategies have also been discussed with these building blocks (Calvo and Vegh, 1999).

4. On the other one: • With few exceptions (Hall, 1988, or Basu and Fernald, 1997 for the case of the United States), empirical evidence regarding the extent of imperfectly competitive markets is lacking. • Evidence on whether inflation dynamics are substantially affected by this feature is even more lacking (De Brouwer and Ericsson, 1995; Mehra, 2000; Bertocco et al, 2002, and Faruquee, 2004 are based on aggregate data). • The deepening of international flows of trade, in view of imperfectly competitive domestic markets, may be a crucial factor behind several successful disinflation stories (Rogoff, 2003). Empirical evidence about this issue is pending as well.

5. Objective • These developments suggest that it is a good time to assess this fruitful micro foundation with the data and ask: • Is imperfect competition pervasive? • How does it affect price formation and dynamics? • In this paper we use the data of the Mexican economy to provide an answer to these two questions. • We determine the extent of imperfect competition in the manufacturing sector, using the method proposed by Panzar and Rosse (1987). 2. We build consumer price indexes of manufactures by perfectly and imperfectly competitive industries and examine their dynamics using error correction models that relate these prices to labor and imported input costs.

6. Main Findings • Imperfect competition is a widespread market structure in manufacturing. • Price adjustment to labor and foreign input cost shocks differs across perfectly and imperfectly competitive industries in the way that theory predicts: • prices of perfectly competitive sectors respond to changes on the exchange rate only, • prices imperfectly competitive sectors respond to changes on the exchange rate and on wages.

7. Main Findings • Price adjustment is estimated to be faster in the former case than in the latter. Therefore, even if in the long run industries where firms enjoy market power do not produce higher inflation, they may slow down the speed of convergence to a given target. • Lower inertia of perfectly competitive industries together with higher exchange rate pass-through also implies that the inflation rate of perfectly competitive industries is more volatile than the inflation of imperfectly competitive industries. • Variations in the perfectly competitive manufactures price index precede those of the imperfectly competitive price index.

8. Related literature: • Recent contributions on the relevance of heterogeneous price setting behavior (Ohanian, Stockman and Kilian, 1995, Chari, Kehoe and McGrattan, 2000, or Bils and Klenow, 2002) • Bils and Klenow find a significant negative correlation between the frequency of price changes the four-firm concentration ratios, the wholesale markup, or the rate of product substitution in the other. • Caucutt et al (1999) document price rigidity in US manufacturing industries and relate it to industry concentration, good durability and the economic cycle.

9. Classifying Perfectly and Imperfectly Competitive Industries • The Panzar-Rosse Statistic is based on a reduced form revenue equation. Although it is less powerful than structural models used for single industry studies, it has less stringent data requirements and lower risk of model misspecification in a study of several industries. • For Mexico’s case this method seems preferable to alternatives based on the cycle properties of the Solow residual (Hall, 1988 or Roeger, 1995): • those methods assume constant price markups and their estimation needs long quarterly time series of value added data. • the effects observed on Mexican manufacturing sector after GATT (1984) and NAFTA (1994) undermine the validity of this assumption.

10. The Panzar-Rosse statistic is defined as: where R* is the revenue function, the wi are the components of the vector w, so that wi denotes the price of the ith input factor. This expression describes a restriction imposed on a profit-maximizing monopoly. • Panzar and Rosse describe other two models so the following industry classification can be obtained:

11. Estimation Method and Data • We use a log linear revenue equation (Shaffer and Disalvo, 1994 and Fischer and Kamerschen, 2003): in which the vector of input prices includes the industry wage, the exchange rate, the price of gas, the price of electricity, and a domestic interest rate. • Output quantity endogeneity is taken care of through two stage least squares estimation (using a lag of output as instrumental variable). • Data set: 71 manufacturing industries of Monthly Industrial Survey (MIS) that can be matched with generic products of Mexico’s Consumer Price Index (47 percent of the manufacturing sector sales on average within January 1994-December 2003).

12. Results • We find: • 12 perfectly competitive industries; • 56 imperfectly competitive industries (43 monopolistically competitive and 13 monopolies). • 3 industries with no statistically significant input prices (classified into the imperfect competitive group, assuming that the list is complete). • During the analysis period, sales of the perfectly competitive industries account for 20.6 percent of all manufacturing sales, while those of imperfectly competitive industries for 26.7 percent.

13. A sample of our results: : :

14. Price Formation and Dynamics in Perfectly and Imperfectly Competitive Industries • Industries are grouped into “competitive” and “imperfectly competitive” ones to build price indexes. The generics contained in the indexes have a weight of 25.8 percent in the CPI and 69.68 percent of the core merchandise price index. • The price index of imperfectly competitive industries has a larger weight in the CPI than the one for the perfectly competitive ones (18.7 percent and 7.1 percent, respectively). Also, the weight of automobiles in the perfectly competitive price index is 3.3 percent. • Annual inflation of perfectly and imperfectly competitive price indexes display a wide gap between them in several episodes.

15. Graph 1 Annual Inflation Rate: Perfectly Competitive vs. Imperfectly Competitive Price Index, Panzar-Rosse Classification (percentage)

16. 12 10 8 6 4 2 0 -2 -4 Jan-91 Jan-85 Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-03 Jan-00 Jan-01 Jan-02 Jan-83 Jan-84 Jan-80 Jan-81 Jan-82 Graph 2 Rolling Variation Coefficient Gap of Perfectly and Imperfectly Competitive Annual Inflation (24 month window) • Also, the volatility of the perfectly competitive annual inflation rate is higher than that of imperfectly competitive manufactures.

17. The correlation coefficient of perfectly and imperfectly competitive inflation first differences according to the Panzar-Rosse classification in periods t and t-I suggests that the first one moves before the second one. Graph 3 Correlation Coefficient: First Difference of Perfectly Competitive Manufactures Inflation in t and Imperfectly Competitive Manufactures Inflation in t-i, January 1990 - November 2003

18. Price Formation and Dynamics • For each price index we estimate the following equation (see Garcés, 2001 and Baillieu et al, 2003): where pt is the log price index, wt is the log nominal wage cost (measured with the average wage quotation of the IMSS), and et is log foreign input cost (measured through the real exchange rate, peso-dollar exchange rate times United States CPI). • pt-1, wt-1 and et-1 constitute the error correction term depicting the long run relationship among the variables (De Brouwer and Ericsson, 1998). Appropriate Johansen cointegration tests indicate that this relationship is stationary. • We report the estimations of this equation for the CPI, the core merchandise price index, the core services price index, and our industry structure price indexes.

19. c2, c3 and c4, are statistically significant and have the expected sign: inflation rises as a response to either wage or exchange rate increases. Price disturbances have a transitory nature and converge to the long term equilibrium level. c5, c6 and c7 that account for the short term effects also have the expected signs, but their statistical significance varies across regressions. • Price indexes of manufactures produced in imperfectly competitive industries show smaller coefficients of lagged exchange rate and lagged price level and a larger coefficient associated to the lagged wage. • Due to the core services component and the fact that perfectly competitive manufactures have a low share in the merchandise component, the CPI dynamics are closer to those of the imperfectly competitive price index. • The adjusted-R2 and the F-statistic respectively suggest good data fit and overall statistical significance. Recursive and rolling regression estimations also show that the coefficients are stable. • Price formation in perfectly competitive industries relies less on past inflation than in imperfectly competitive industries.

20. Table 2 Estimation Results of Price Error Correction Models of Perfectly and Imperfectly Competitive Manufactures

21. Long run pass through coefficients of the CPI coincide with the previous studies. Those for the inflation rate in the perfectly competitive industries show that price dynamics depend mostly on the exchange rate. For imperfectly competitive industries there is both exchange rate and wage pass-through • The pass-through coefficients are similar whether a threshold of import to domestic sales is used and for different specifications of the Panzar-Rosse revenue equation. Table 3 Pass-Through Coefficients of Wage and Exchange Rate of Perfectly and Imperfectly Competitive Manufactures

22. For both wages and the exchange rate periods in which the prices of one sector show a higher pass-through than the other are observed. After 2002, it seems that the exchange rate pass through has been higher for the perfectly competitive index and lower for the imperfectly competitive index, while the wage pass through has had the opposite pattern. Graph 4 Rolling Regression Estimates of the Exchange Rate Pass Through Graph 5 Rolling Regression Estimates of the Wage Pass-Through

23. Some Policy Implications • The inflation dynamics of perfectly competitive manufactures is consistent with the law of one price, while in imperfectly competitive manufactures wage variations also affect prices, consistent with a cost push. • However, further analysis does not support the cost push view: the only weakly exogenous variable of the system is the price level. Thus, the central bank’s policy does matter in determining firms’ ability to pass forward higher wage costs into higher product prices. • That perfectly competitive manufactures have a lower degree of inflationary inertia than imperfectly competitive industries may imply different employment responses. Also, that an inflationary bout could produce a significant relative price misalignment between the goods produced in perfectly and imperfectly competitive industries (Ohanian, Stockman and Kilian, 1995 or Bils and Klenow, 2002).

24. Table A7Pass-Through Coefficients of Wage and Exchange Rate of Manufactures with Import Penetration Rate above and below 30 Percent • Are the price formation processes described solely explained by foreign competition? We find that both among manufactures with a high and low import penetration rate, the perfectly competitive ones again exhibit higher exchange rate coefficients and lower wage coefficients than the imperfectly competitive ones. This suggests an affirmative answer to Rogoff (2003). Some robustness checks:

25. Table A9Pass-Through Coefficients of Wage and Exchange Rate of Manufactures with Concentration Ratio CR4 above and below 18 Percent • Does the Panzar-Rosse Index add tell something different or additional to seller concentration (C4)? Some robustness checks:

26. Price flexibility, durability, industry concentration, degree of competition and import penetration. • If competition degree, import penetration and seller concentration affect price dynamics, which matters most? • Caucutt et al (1999) define price change amplitude (PA) as the average over a time period of |Pt|=|log(Pt/Pt-1)| Extensions:

27. Why we are not inside those bands anymore?