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Pricing Policy in the Swedish Automobile Market
Pricing Policy in the Swedish Automobile Market Manuchehr Irandoust*
This paper analyzes the phenomenon of pricing to market in the Swedish auto market. First, it estimates, with the help of hedonic regression, the pricing and product policies of the major car producers. Second, the impact of the exchange rate variations, quality effects and cost differences on pricing behavior are examined by developing and evaluating econometric models for a sample of the major car exporting countries. The results suggest that exchange rate changes, quality dimension, and cost changes play a significant role in explaining actual car prices in the Swedish market. © 1998 Elsevier Science Inc. Keywords: Markup adjustment; Price stabilization; Pricing to market JEL classification: L2; L6
I. Introduction It has been observed that the local currency prices of imported goods are often insensitive to exchange-rate changes. Such a case creates differences in the relative prices of internationally-traded goods and has important economic theory and policy implications [Le Cacheux and Reichlin (1992); Kirman and Schueller (1992)]. On theoretical grounds, this phenomenon is often referred to as “pricing to market,” and reflects the view that exporters reduce markups for importers whose currencies have depreciated against the exporter’s, thereby stabilizing prices in the importer’s currency relative to a constant markup [Krugman (1987)]. This emphasizes the importance of imperfect competition and dynamic adjustment in international trade. A large body of literature has grown up on the exchange-rate pass-through, and these studies have shown that pricing to market is not a global phenomenon but it is limited to markets for differentiated products. In other words, explanations of the phenomenon concentrate on standard models of imperfect competition in which model characteristics
¨ rebro, O ¨ rebro, Sweden. University of O ¨ rebro, Department of Economics, SE-701 82 Address correspondence to: Dr. M. Irandoust, University of O ¨ rebro, Sweden. O
Journal of Economics and Business 1998; 50:309 –317 © 1998 Elsevier Science Inc., New York, New York
0148-6195 / 98 / $19.00 PII S0148-6195(98)00006-X
310
Pricing Policy in the Swedish Automobile Market
differ by industry. Theoretical work has considered both static and dynamic models. The static models emphasize market behavior and demand elasticities as determinants of pass-through equations [Knetter (1989, 1993, 1995); Gagnon and Knetter (1995); Marston (1990)] and dynamic models permit expectations about the exchange-rate process in conjunction with demand and/or supply dynamics [Le Cacheux and Reichlin (1992); Froot and Klemperer (1988); Giovannini (1988); Kasa (1992)]. The automobile industry has been the most interesting example of pricing to market behavior [Feenstra (1985, 1989); Gagnon and Knetter (1995); Melo and Messerlin (1988)]. The exchange-rate issue is particularly interesting in the Swedish case, as the Swedish Krona (SEK) has experienced dramatic swings during the 1970s and 1980s. (In 1977, 1981, 1982, the SEK was devalued by 16%, 10%, and 16%, respectively.) Automobile prices are not only affected by exchange-rate changes, but also by changes in characteristics of existing vehicle types. Therefore, exchange-rate pass-through effects cannot be identified unless the quality dimension is taken into consideration. Do foreign firms change their prices in the Swedish car market when the Swedish exchange rate changes? Do source-country effects appear to be important in determining the extent of pricing to the Swedish car market? Do quality dimension and cost changes affect actual car prices in the Swedish market? These are the main questions addressed in this paper concerning the Swedish car market. I was able to obtain actual car prices for Japanese, Italian, German, British, and French firms in Sweden for the period 1976 –1985. The choice of the period of the study is justified by two reasons. First, the structure of the Swedish car market was mainly based on the above-mentioned source countries. Since the late 1980s, the importance of imports from transplants belonging to Japanese firms in Europe has increased. This was likely due to a voluntary export restraint which was imposed in 1988 between Sweden and Japan in order to limit Japanese exports to Sweden (Japan took advantage of its European transplants since there was a free-trade agreement between Sweden and other European countries). Second, the period of study contains only a fixed exchange-rate system. In the beginning of the 1990s, Sweden changed exchangerate regimes from fixed to floating. Sapir and Sekkat (1995) argued that the higher the degree of uncertainty concerning changes in the exchange rates which is associated with a floating exchange rate regime, the more firms are likely to use markup adjustment to stabilize local currency prices. Thus, it is probable that the pass-through of exchange-rate changes into import prices will be less under a floating exchange-rate regime than under a fixed exchange-rate regime. These factors affect individual exporters differently in their performance and pricing behavior. In order to avoid these problems, we concentrate only on the period between 1976 and 1985. Finally, the use of actual car prices in lieu of export unit values, with their well-known defects, enabled us to perform a very good experiment with the data (transport costs and taxes included in prices are likely to be swamped by variation in exchange rates). The paper is organized as follows. Section II studies the pricing and product policies of car producers on the Swedish market. Section III provides some theoretical considerations. The empirical specification and data sets used in this study are explained in Section IV. The results from model estimations are presented and interpreted in Section V. Section VI concludes the paper. Data definitions and sources are cited in the Appendix.
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Table 1. Hedonic Regressions by Supplying Countries. Dependent Variable: Natural Logarithm of Model Price Variables Intercept L 3 W 3 W* Horsepower (100 HP) Year 1977 Year 1978 Year 1979 Year 1980 Year 1981 Year 1982 Year 1983 Year 1984 Year 1985 R# 2 MSE n
Japanese Cars
Italian Cars
German Cars
French Cars
Swedish Cars
British Cars
9.326 (276.83) 0.030 (5.24) 0.808 (16.70) 0.158 (5.18) 0.352 (11.41) 0.429 (13.89) 0.465 (14.46) 0.523 (17.57) 0.574 (18.84) 0.691 (23.54) 0.838 (29.04) 0.892 (31.87) 0.93 0.010 283
9.437 (208.03) 0.019 (1.94) 0.768 (13.63) 0.095 (2.43) 0.258 (6.81) 0.356 (9.45) 0.435 (10.78) 0.500 (11.63) 0.506 (12.46) 0.580 (14.20) 0.687 (17.24) 0.795 (20.06) 0.94 0.011 159
9.486 (175.84) 0.055 (13.46) 0.616 (27.21) 0.019 (0.35) 0.177 (3.16) 0.289 (5.24) 0.351 (6.42) 0.401 (7.05) 0.438 (7.88) 0.626 (11.35) 0.695 (13.43) 0.744 (14.51) 0.86 0.228 417
9.488 (335.22) 0.088 (22.30) 0.146 (3.48) 0.081 (2.86) 0.201 (7.22) 0.317 (10.91) 0.438 (15.05) 0.500 (18.29) 0.538 (17.94) 0.616 (20.56) 0.723 (24.86) 0.805 (27.11) 0.93 0.010 267
9.332 (135.57) 0.057 (6.89) 0.579 (11.28) 0.116 (2.42) 0.235 (4.85) 0.318 (6.71) 0.367 (7.82) 0.419 (9.06) 0.471 (9.86) 0.633 (13.19) 0.755 (15.71) 0.789 (16.32) 0.90 0.016 187
9.244 (112.55) 0.104 (15.48) 0.363 (8.17) 0.084 (0.86) 0.187 (2.05) 0.369 (3.77) 0.875 (5.81) 0.758 (5.46) 0.846 (6.07) 0.871 (5.89) 1.188 (9.50) 1.207 (10.05) 0.95 0.089 119
Notes: L, W, and W* are length (m), width (m), and weight (tons), respectively. Figures in parentheses are t values. Sources: Alla Bilar, and Jan Ullens Bilfakta 1976–1985.
II. Prices and Quality on the Swedish Car Market The main purpose of this section is to analyze how prices of foreign and domesticallyproduced cars are changing on the Swedish car market. To achieve this, I have employed the technique known as hedonic price regression, developed by Griliches (1971), to explore the pricing policies of car manufacturers on the Swedish market. Hedonic regressions relate the prices of car models to the characteristics of these models. The new car prices used here are actual car prices (retail prices). The selected characteristics are length, width, weight, and horsepower. The samples consist of all major car models available each year on the Swedish market, with the exception of a few German car models for which information was incomplete. Table 1 presents results from the hedonic price estimations for the car-exporting countries. Data were pooled over the period 1976 –1985, and yearly dummy variables were included in the regressions to capture the nominal price increases not explained by changes in quality within or across models. Because the equations are formulated in semilogarithmic form, the coefficients of the yearly dummy variables provide us with an estimate of the average percentage increase in the price of the car models or varieties included in the sample, between two periods, holding quality constant.
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The selected characteristics exhibit the expected positive signs and were statistically significant at conventional levels. They account for most of the variance in the logarithm of the price of the models during the period (between 86% and 95%). The annual dummy variables, which were expected to capture the quality-adjusted rise in nominal prices, were positive and statistically significant at conventional levels (the only exception is 1977 when the dummy for Germany and Britain was insignificant). Table 1 shows the different price-increase strategies of the supplying countries. The average quality-adjusted prices for British cars offered on the market had the most rapid increase between 1976 and 1985, followed in order of magnitude by Japanese, French, Italian, Swedish, and German cars, respectively. Is an increase in actual car prices on the Swedish market due to changes in quality, in higher production costs, or to exchange rate increases? In order to evaluate the robustness of these relationships, it is necessary to have a theoretical and empirical framework.
III. Theoretical Considerations The model used here follows Knetter (1989, 1993, 1995) as well as Gagnon and Knetter (1995). It is a partial equilibrium analysis and there are no adjustment costs or uncertainty. Consider a monopolist who produces goods (by employing a single factor of production) for sale in a given destination market. The profits of the monopolist, P, from sales in the foreign market are given by:
P ~ p ! 5 pq ~ ep ! 2 c @ q ~ ep ! , v # ,
(1)
where p is the export price (expressed as price in the exporter’s currency); q is the quantity demanded, which is a function of the price in the importer’s currency; e is the exchange rate (in units of the importer’s currency per unit of the exporter’s currency); v is the input price in the exporter’s currency, and c(q, v) is the firm’s cost function. The first-order conditions for profit maximization are:
P/p 5 pq9 ~ ep ! 1 q ~ ep ! 2 MCq9 ~ ep ! 5 0,
(2)
where MC denotes the derivative of the cost function with respect to q, i.e., marginal cost. The arguments of MC have been suppressed for simplicity. Manipulation allows equation (2) to be written as the familiar condition that the monopolist equates marginal revenue to marginal cost. (Note that the maximization can easily be recast in terms of real prices and profits.) Finally, the export price to a given destination market is the product of marginal cost and a destination-specific markup:
p 5 MC @ h / ~ h 2 1 !# ,
(3)
where h is the absolute value of the elasticity of demand in the foreign market with respect to changes in price. The equation given by (3) reveals that price is a markup over marginal cost, where the markup is determined by the elasticity of demand in the foreign market. In other words, a change in the exchange rate vis-a-vis the currency of a given destination market can influence the price charged to the market in two ways: by affecting either marginal cost (via changes in quantity or input prices) or the elasticity of import demand, which is destination-specific. The degree of pass-through is determined by these two effects, but pricing to market refers to the second effect only. (These two effects become
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more clear by taking the log of equation (3) and totally differentiating the resulting expression with respect to export prices, input prices and exchange rates.) Firm-specific characteristics are also important in pricing to market behavior. The existence of significant economies of scale may stimulate pricing to market behavior. For example, in the presence of devaluation (or depreciation) of the destination market’s currency, foreign firms may wish to maintain their volume of sales in order to reduce costs created by economies of scale. Other factors such as differences in profit orientation between firms and countries are also important in pricing to market behavior. This is because of the fact that different firms have different kinds of ownership and control structures depending on the source countryspecific characteristics which they are enterprising.
IV. Empirical Specification and Data Table 1 shows that the characteristics of existing vehicle types are quite important in explaining price changes. Thus, exchange-rate pass-through effects cannot be addressed unless the changes of existing vehicle attributes and quality dimensions are taken into consideration. To control for the effect of cost changes on prices, I used unit labor cost which provides a direct measure of a significant component of a firm’s marginal costs. A set of time dummies was also included in the model in order to capture unobservable factors which were constant across individual firms but varied over time (note that the time dummies take care of the effect of any other changes on prices which occurred during the period of the study in the source country and destination market, e.g., any external shocks like an oil crisis, oil embargo, and the subsequent increase in the price of gasoline). Thus, the price charged to any given destination varies due to changes in marginal cost and in the markup over marginal cost. The markup to a given market is influenced by destination-specific variables such as exchange rates and other prices. The model of actual car price adjustment for a given destination market can be written as follows:
ln p ijt 5 a 1 b i ln e it 1 d ln LWW *ijt 1 m ln HP ijt 1 s ln ULC it 1 w t 1 « ijt ,
(4)
where i, j, and t are indexes for source countries, car models and time periods, respectively; p is the actual car price (i.e., retail price, measured in units of the exporter’s currency divided by the respective source country’s consumer price index); e is the exchange rate (expressed as units of the buyer’s currency per unit of the seller’s divided by the destination’s consumer price index and multiplied by the respective source country’s consumer price index); LWW* represents the selected characteristics of car models (i.e., L 3 W 3 W*, length, width, and weight); HP is the horsepower; ULC is the unit labor cost (defined as the ratio of labor cost to labor productivity, and is expressed in each respective source country’s currency deflated by the corresponding consumer price index); w represents the time dummies. The error term, «ijt, is assumed to be independently and identically distributed. (The definitions and sources of the variables are also provided in the Appendix.) The interpretation of b is derived from Knetter (1995). A value of b equal to zero means that the markup to a particular destination is independent of fluctuations in the value of the seller’s currency against the buyer’s. This implies that changes in currency values are fully passed through to the buyer. A value of b equal to zero also implies that
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demand schedules have constant elasticity with respect to price when the exporter is a monopolist. Negative values of b indicate that markup adjustment is associated with stabilization of local currency prices. A value of 20.5, for example, implies that in response to a 10% depreciation or appreciation of the buyer’s own currency, the markup would be increased or reduced by 5%. In other words, the price paid in unit of the buyer’s currency would rise or fall by only 5% (given constant costs). Negative values of b also imply that when the exporter is a monopolist, demand is less convex than a constant elasticity demand schedule. In the absence of quantity adjustment, one would expect to observe complete price stability in local currency units, i.e., a b of minus one. (As quantity adjustment takes place, prices in local currency units change and the value of b would also adjust towards zero.) Positive values of b imply that destination-specific markups change in a way which amplifies the effect of destination-specific exchange-rate changes on the price in terms of the buyer’s currency.
V. Estimation Results The estimates of coefficients derived by pooling the data for all the source countries are presented in Table 2. In order to evaluate the robustness of the results, different specifications of model (4) were tested to expose the effects of including or excluding variables. First, the model was estimated without time dummies. Second, the model was tested by a simple time trend variable (a dummy variable) in order to investigate if there was any time trend in the data. Third, the model was estimated by a set of time dummies. Finally, it was of interest to split up the LWW* variable to see whether the coefficients of exchange rates were affected. Most of the exchange rate coefficients revealed strong evidence of pricing to market and were statistically significant at conventional levels. Negative values of exchange rate coefficients imply that there is a very strong tendency to stabilize foreign currency prices in the car industry. For the Japanese, British, Italian, and German car exporters, the results are consistent with the price stabilization in local currency terms, e.g., a coefficient of 20.6 in the case of Japanese firms implies that a 10% depreciation of the SEK would result in an increase of the markup of Japanese firms in the Swedish car market by 6%. For the French car exporters, the price adjustment pattern was very different in character. Zero values of the exchange rate coefficients imply that the markup adjustment associated with exchange rate changes was unresponsive to fluctuations in the seller’s currency against the buyer’s. This is in stark contrast to the Italian, German, British, and Japanese car exporters’ behavior. The magnitude of the estimated coefficients and the implied fluctuations in actual prices suggest that Japan, Britain, Italy, and Germany had much larger profit margins than France for average levels of the exchange rate. The characteristics of vehicle types exhibited expected signs and were statistically significant at conventional levels in specifications 1–3, as indicated by Table 2. This implies that quality dimension is important in determining actual car prices. Specification (4) indicates that the length variable had a negative and significant coefficient, and the width variable was not significant, both of which were unexpected. These may be due to collinearity with other characteristics or misspecification of the equation. Unit labor costs showed expected signs and was statistically significant at conventional levels, as indicated by Table 2. This means that actual car prices are highly dependent on unit labor costs as a direct measure of a significant component of a firm’s marginal costs.
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Table 2. Estimates of Actual Price Adjustment Dependent Variable: ln pijt Variables/Specifications
(1)
Intercept
0.100 (0.87) 0.693 (24.47) 0.494 (14.90)
ln HPijt ln LWW*ijt
(2) 0.223 (1.01) 0.692 (24.42) 0.496 (14.89)
(3)
(4)
20.268 (21.11) 0.685 (24.45) 0.507 (15.37)
20.930 (20.81) 0.601 (22.58)
0.318 (12.31)
0.280 (4.39)
0.448 (6.39)
21.680 (29.72) 0.246 (0.78) 1.575 (18.60) 0.425 (6.56)
20.732 (232.74) 20.627 (229.12) 20.661 (224.43) 20.595 (211.77) 0.021 (1.46)
20.763 (214.75) 20.649 (215.97) 20.700 (210.73) 20.637 (27.80) 0.021 (1.50) 0.004 (0.66)
20.632 (211.23) 20.550 (212.32) 20.532 (27.47) 20.438 (24.80) 0.002 (0.11)
20.653 (212.56) 20.595 (214.41) 20.547 (28.31) 20.436 (25.18) 0.001 (0.04)
20.085 (22.38) 20.112 (22.81) 20.116 (22.61) 20.183 (23.55) 20.160 (23.10) 20.236 (24.00) 20.211 (23.17) 20.149 (22.20) 20.107 (21.61) 0.99 0.066 1245
20.082 (22.49) 20.089 (22.41) 20.094 (22.28) 20.168 (23.52) 20.149 (23.10) 20.212 (23.87) 20.191 (23.11) 20.124 (21.97) 20.083 (21.35) 0.99 0.056 1245
ln Lijt ln Wijt ln W*ijt ln ULCit Exporter-Specific Exchange Rates (ln eit): Japan Britain Italy Germany France Time trend Time Dummies (wt): D–77 D–78 D–79 D–80 D–81 D–82 D–83 D–84 D–85 R# 2 MSE n
0.99 0.067 1245
Note: Figures in parentheses are t values.
0.99 0.067 1245
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Pricing Policy in the Swedish Automobile Market
Aside from the negative sign on length variable, the results appear to be insensitive to the alternative specifications.
VI. Conclusions This paper examined the pricing policy of foreign car manufacturers in the Swedish market in order to reveal the degree of pass-through of exchange-rate fluctuations to the consumer price paid in Sweden. The model was designed to compare the extent of pricing to market of car manufacturers by disclosing the impact of differences in the supply source on the elasticity of the domestic price of imported cars to changes in the bilateral rate of exchange rates. The results reveal that actual car price adjustments in the car industry were responsive to changes in exchange rates, costs, and quality. The estimated values of the exchange rate coefficients implied that pricing to market behavior was more pronounced in Japanese export pricing than for British, Italian, and German exports. Adjustments were undertaken to stabilize local currency prices. The results also indicate that French prices were insensitive to exchange-rate fluctuations. The quality dimension and unit labor cost, which provided a direct measure of a significant component of firms’ marginal costs, were important in determining actual car prices.
I would like to thank Lennart Hjalmarsson, Niklas Karlsson, Bo Walfridson, an anonymous referee, and editors ¨ rebro is acknowlof the Journal for comments on a previous draft. Financial support from the University of O edged. Remaining errors and ambiguities are my responsibility.
Appendix Definition of Variables and Data Sources pijt: Actual car prices (retail prices), converted to respective exporter’s currency by exchange rates and divided by respective source country’s CPI. Sources: Alla Bilar (1976 –1985), Stockholm; Jan Ullens Bilfakta (1976 –1985), Stockholm; International Financial Statistics (various issues), Washington DC; Swedish Employers’ Confederation (1987), Wages and Total Labour Costs for Workers: International Survey, Stockholm. eit: Exchange rates, defined as destination market currency per unit of the exporter’s currency divided by the destination’s CPI and multiplied by each respective sourcecountry’s CPI. Source: International Financial Statistics (various issues), Washington DC; International Monetary Fund (various issues), Washington DC; Swedish Employers’ Confederation (1987), Wages and Total Labour Costs for Workers: International Survey, Stockholm. HPijt: Horsepower. Sources: Alla Bilar (1976 –1985), Stockholm; Jan Ullens Bilfakta (1976 –1985), Stockholm. (L 3 W 3 W*)ijt: Length (m), width (m), and weight (tons). Sources: Alla Bilar (1976–1985), Stockholm; Jan Ullens Bilfakta (1976–1985), Stockholm.
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ULCit: Unit labor cost, i.e., the ratio of labor cost to labor productivity. The former was measured per working hour at the four-digit car industry level (ISIC 3843). Labor costs were given in SEK and converted to respective exporter currencies, then deflated by each respective source-country’s CPI. Labor productivity is the production of car per hour. It was measured as the production of cars divided by the number of hours worked in the manufacturing of transport equipment (ISIC, 384). Sources: Industrial Statistics Yearbook, Vol. 1, United Nations (various issues), New York; International Labor Office (various issues), Geneva; Swedish Employers’ Confederation (1987), Wages and Total Labour Costs for Workers: International Survey, Stockholm; Yearbook of Labor Statistics (various issues), Geneva.
References Feenstra, R. 1985. Automobile price and protection: The US-Japan trade restraints. Journal of Policy Modeling 7:49–68. Feenstra, R. 1989. Symmetric pass-through of tariffs and exchange rates under imperfect competition: An empirical test. Journal of International Economics 27:25–45. Froot, K., and Klemperer, P. 1989. Exchange rate pass-through when market share matters. The American Economic Review 79:637–654. Gagnon, J., and Knetter, M. 1995. Markup adjustment and exchange rate fluctuations: Evidence from panel data on automobiles and total manufacturing. Journal of International Money and Finance 14(2):289–310. Giovannini, A. 1988. Exchange rates and traded goods prices. Journal of International Economics 24:45–68. Griliches, Z. 1971. Hedonic price indexes for automobiles: An econometric analysis of quality change. In Price Indexes and Quality Change (Z. Griliches, ed.). Cambridge: Harvard University Press, pp. 55–87. Kasa, K. 1992. Adjustment costs and pricing to market: Theory and evidence. Journal of International Economics 32:1–30. Kirman, A., and Schueller, N. 1990. Price leadership and discrimination in the European car market. The Journal of Industrial Economics 39:69–91. Knetter, M. 1989. Price discrimination by U.S. and German exporters. The American Economic Review 79:198–210. Knetter, M. 1993. International comparisons of pricing to market behavior. The American Economic Review 83(3):473–486. Knetter, M. 1995. Pricing to market in response to unobservable and observable shocks. International Economic Journal 9(2):1–26. Krugman, P. 1987. Pricing to market when exchange rate changes. In Real-Financial Linkages Among Open Economies (S. W. Arndt and J. D. Richardson, eds.). Cambridge: MIT Press. Le Cacheux, J., and Reichlin, L. 1992. Exchange rates and import prices: Evidence of pricing to market in European car market. In International Trade Modelling (M. G. Dagenais and P. A. Muet, eds.). London: Chapman & Hall. Marston, R. 1990. Pricing to market in Japanese manufacturing. Journal of International Economics 29:217–236. Melo de, J., and Messerlin, P. 1988. Price, quality and welfare effects of European VERs on Japanese autos. European Economic Review 32:1527–1546. Sapir, A., and Sekkat, K. 1995. Exchange rate regimes and trade prices: Does the EMS Matter? Journal of International Economics 38(1):75–94.
This paper analyzes the phenomenon of pricing to market in the Swedish auto market. First, it estimates, with the help of hedonic regression, the pricing and product policies of the major car producers. Second, the impact of the exchange rate variations, quality effects and cost differences on pricing behavior are examined by developing and evaluating econometric models for a sample of the major car exporting countries. The results suggest that exchange rate changes, quality dimension, and cost changes play a significant role in explaining actual car prices in the Swedish market. © 1998 Elsevier Science Inc. Keywords: Markup adjustment; Price stabilization; Pricing to market JEL classification: L2; L6
I. Introduction It has been observed that the local currency prices of imported goods are often insensitive to exchange-rate changes. Such a case creates differences in the relative prices of internationally-traded goods and has important economic theory and policy implications [Le Cacheux and Reichlin (1992); Kirman and Schueller (1992)]. On theoretical grounds, this phenomenon is often referred to as “pricing to market,” and reflects the view that exporters reduce markups for importers whose currencies have depreciated against the exporter’s, thereby stabilizing prices in the importer’s currency relative to a constant markup [Krugman (1987)]. This emphasizes the importance of imperfect competition and dynamic adjustment in international trade. A large body of literature has grown up on the exchange-rate pass-through, and these studies have shown that pricing to market is not a global phenomenon but it is limited to markets for differentiated products. In other words, explanations of the phenomenon concentrate on standard models of imperfect competition in which model characteristics
¨ rebro, O ¨ rebro, Sweden. University of O ¨ rebro, Department of Economics, SE-701 82 Address correspondence to: Dr. M. Irandoust, University of O ¨ rebro, Sweden. O
Journal of Economics and Business 1998; 50:309 –317 © 1998 Elsevier Science Inc., New York, New York
0148-6195 / 98 / $19.00 PII S0148-6195(98)00006-X
310
Pricing Policy in the Swedish Automobile Market
differ by industry. Theoretical work has considered both static and dynamic models. The static models emphasize market behavior and demand elasticities as determinants of pass-through equations [Knetter (1989, 1993, 1995); Gagnon and Knetter (1995); Marston (1990)] and dynamic models permit expectations about the exchange-rate process in conjunction with demand and/or supply dynamics [Le Cacheux and Reichlin (1992); Froot and Klemperer (1988); Giovannini (1988); Kasa (1992)]. The automobile industry has been the most interesting example of pricing to market behavior [Feenstra (1985, 1989); Gagnon and Knetter (1995); Melo and Messerlin (1988)]. The exchange-rate issue is particularly interesting in the Swedish case, as the Swedish Krona (SEK) has experienced dramatic swings during the 1970s and 1980s. (In 1977, 1981, 1982, the SEK was devalued by 16%, 10%, and 16%, respectively.) Automobile prices are not only affected by exchange-rate changes, but also by changes in characteristics of existing vehicle types. Therefore, exchange-rate pass-through effects cannot be identified unless the quality dimension is taken into consideration. Do foreign firms change their prices in the Swedish car market when the Swedish exchange rate changes? Do source-country effects appear to be important in determining the extent of pricing to the Swedish car market? Do quality dimension and cost changes affect actual car prices in the Swedish market? These are the main questions addressed in this paper concerning the Swedish car market. I was able to obtain actual car prices for Japanese, Italian, German, British, and French firms in Sweden for the period 1976 –1985. The choice of the period of the study is justified by two reasons. First, the structure of the Swedish car market was mainly based on the above-mentioned source countries. Since the late 1980s, the importance of imports from transplants belonging to Japanese firms in Europe has increased. This was likely due to a voluntary export restraint which was imposed in 1988 between Sweden and Japan in order to limit Japanese exports to Sweden (Japan took advantage of its European transplants since there was a free-trade agreement between Sweden and other European countries). Second, the period of study contains only a fixed exchange-rate system. In the beginning of the 1990s, Sweden changed exchangerate regimes from fixed to floating. Sapir and Sekkat (1995) argued that the higher the degree of uncertainty concerning changes in the exchange rates which is associated with a floating exchange rate regime, the more firms are likely to use markup adjustment to stabilize local currency prices. Thus, it is probable that the pass-through of exchange-rate changes into import prices will be less under a floating exchange-rate regime than under a fixed exchange-rate regime. These factors affect individual exporters differently in their performance and pricing behavior. In order to avoid these problems, we concentrate only on the period between 1976 and 1985. Finally, the use of actual car prices in lieu of export unit values, with their well-known defects, enabled us to perform a very good experiment with the data (transport costs and taxes included in prices are likely to be swamped by variation in exchange rates). The paper is organized as follows. Section II studies the pricing and product policies of car producers on the Swedish market. Section III provides some theoretical considerations. The empirical specification and data sets used in this study are explained in Section IV. The results from model estimations are presented and interpreted in Section V. Section VI concludes the paper. Data definitions and sources are cited in the Appendix.
M. Irandoust
311
Table 1. Hedonic Regressions by Supplying Countries. Dependent Variable: Natural Logarithm of Model Price Variables Intercept L 3 W 3 W* Horsepower (100 HP) Year 1977 Year 1978 Year 1979 Year 1980 Year 1981 Year 1982 Year 1983 Year 1984 Year 1985 R# 2 MSE n
Japanese Cars
Italian Cars
German Cars
French Cars
Swedish Cars
British Cars
9.326 (276.83) 0.030 (5.24) 0.808 (16.70) 0.158 (5.18) 0.352 (11.41) 0.429 (13.89) 0.465 (14.46) 0.523 (17.57) 0.574 (18.84) 0.691 (23.54) 0.838 (29.04) 0.892 (31.87) 0.93 0.010 283
9.437 (208.03) 0.019 (1.94) 0.768 (13.63) 0.095 (2.43) 0.258 (6.81) 0.356 (9.45) 0.435 (10.78) 0.500 (11.63) 0.506 (12.46) 0.580 (14.20) 0.687 (17.24) 0.795 (20.06) 0.94 0.011 159
9.486 (175.84) 0.055 (13.46) 0.616 (27.21) 0.019 (0.35) 0.177 (3.16) 0.289 (5.24) 0.351 (6.42) 0.401 (7.05) 0.438 (7.88) 0.626 (11.35) 0.695 (13.43) 0.744 (14.51) 0.86 0.228 417
9.488 (335.22) 0.088 (22.30) 0.146 (3.48) 0.081 (2.86) 0.201 (7.22) 0.317 (10.91) 0.438 (15.05) 0.500 (18.29) 0.538 (17.94) 0.616 (20.56) 0.723 (24.86) 0.805 (27.11) 0.93 0.010 267
9.332 (135.57) 0.057 (6.89) 0.579 (11.28) 0.116 (2.42) 0.235 (4.85) 0.318 (6.71) 0.367 (7.82) 0.419 (9.06) 0.471 (9.86) 0.633 (13.19) 0.755 (15.71) 0.789 (16.32) 0.90 0.016 187
9.244 (112.55) 0.104 (15.48) 0.363 (8.17) 0.084 (0.86) 0.187 (2.05) 0.369 (3.77) 0.875 (5.81) 0.758 (5.46) 0.846 (6.07) 0.871 (5.89) 1.188 (9.50) 1.207 (10.05) 0.95 0.089 119
Notes: L, W, and W* are length (m), width (m), and weight (tons), respectively. Figures in parentheses are t values. Sources: Alla Bilar, and Jan Ullens Bilfakta 1976–1985.
II. Prices and Quality on the Swedish Car Market The main purpose of this section is to analyze how prices of foreign and domesticallyproduced cars are changing on the Swedish car market. To achieve this, I have employed the technique known as hedonic price regression, developed by Griliches (1971), to explore the pricing policies of car manufacturers on the Swedish market. Hedonic regressions relate the prices of car models to the characteristics of these models. The new car prices used here are actual car prices (retail prices). The selected characteristics are length, width, weight, and horsepower. The samples consist of all major car models available each year on the Swedish market, with the exception of a few German car models for which information was incomplete. Table 1 presents results from the hedonic price estimations for the car-exporting countries. Data were pooled over the period 1976 –1985, and yearly dummy variables were included in the regressions to capture the nominal price increases not explained by changes in quality within or across models. Because the equations are formulated in semilogarithmic form, the coefficients of the yearly dummy variables provide us with an estimate of the average percentage increase in the price of the car models or varieties included in the sample, between two periods, holding quality constant.
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The selected characteristics exhibit the expected positive signs and were statistically significant at conventional levels. They account for most of the variance in the logarithm of the price of the models during the period (between 86% and 95%). The annual dummy variables, which were expected to capture the quality-adjusted rise in nominal prices, were positive and statistically significant at conventional levels (the only exception is 1977 when the dummy for Germany and Britain was insignificant). Table 1 shows the different price-increase strategies of the supplying countries. The average quality-adjusted prices for British cars offered on the market had the most rapid increase between 1976 and 1985, followed in order of magnitude by Japanese, French, Italian, Swedish, and German cars, respectively. Is an increase in actual car prices on the Swedish market due to changes in quality, in higher production costs, or to exchange rate increases? In order to evaluate the robustness of these relationships, it is necessary to have a theoretical and empirical framework.
III. Theoretical Considerations The model used here follows Knetter (1989, 1993, 1995) as well as Gagnon and Knetter (1995). It is a partial equilibrium analysis and there are no adjustment costs or uncertainty. Consider a monopolist who produces goods (by employing a single factor of production) for sale in a given destination market. The profits of the monopolist, P, from sales in the foreign market are given by:
P ~ p ! 5 pq ~ ep ! 2 c @ q ~ ep ! , v # ,
(1)
where p is the export price (expressed as price in the exporter’s currency); q is the quantity demanded, which is a function of the price in the importer’s currency; e is the exchange rate (in units of the importer’s currency per unit of the exporter’s currency); v is the input price in the exporter’s currency, and c(q, v) is the firm’s cost function. The first-order conditions for profit maximization are:
P/p 5 pq9 ~ ep ! 1 q ~ ep ! 2 MCq9 ~ ep ! 5 0,
(2)
where MC denotes the derivative of the cost function with respect to q, i.e., marginal cost. The arguments of MC have been suppressed for simplicity. Manipulation allows equation (2) to be written as the familiar condition that the monopolist equates marginal revenue to marginal cost. (Note that the maximization can easily be recast in terms of real prices and profits.) Finally, the export price to a given destination market is the product of marginal cost and a destination-specific markup:
p 5 MC @ h / ~ h 2 1 !# ,
(3)
where h is the absolute value of the elasticity of demand in the foreign market with respect to changes in price. The equation given by (3) reveals that price is a markup over marginal cost, where the markup is determined by the elasticity of demand in the foreign market. In other words, a change in the exchange rate vis-a-vis the currency of a given destination market can influence the price charged to the market in two ways: by affecting either marginal cost (via changes in quantity or input prices) or the elasticity of import demand, which is destination-specific. The degree of pass-through is determined by these two effects, but pricing to market refers to the second effect only. (These two effects become
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more clear by taking the log of equation (3) and totally differentiating the resulting expression with respect to export prices, input prices and exchange rates.) Firm-specific characteristics are also important in pricing to market behavior. The existence of significant economies of scale may stimulate pricing to market behavior. For example, in the presence of devaluation (or depreciation) of the destination market’s currency, foreign firms may wish to maintain their volume of sales in order to reduce costs created by economies of scale. Other factors such as differences in profit orientation between firms and countries are also important in pricing to market behavior. This is because of the fact that different firms have different kinds of ownership and control structures depending on the source countryspecific characteristics which they are enterprising.
IV. Empirical Specification and Data Table 1 shows that the characteristics of existing vehicle types are quite important in explaining price changes. Thus, exchange-rate pass-through effects cannot be addressed unless the changes of existing vehicle attributes and quality dimensions are taken into consideration. To control for the effect of cost changes on prices, I used unit labor cost which provides a direct measure of a significant component of a firm’s marginal costs. A set of time dummies was also included in the model in order to capture unobservable factors which were constant across individual firms but varied over time (note that the time dummies take care of the effect of any other changes on prices which occurred during the period of the study in the source country and destination market, e.g., any external shocks like an oil crisis, oil embargo, and the subsequent increase in the price of gasoline). Thus, the price charged to any given destination varies due to changes in marginal cost and in the markup over marginal cost. The markup to a given market is influenced by destination-specific variables such as exchange rates and other prices. The model of actual car price adjustment for a given destination market can be written as follows:
ln p ijt 5 a 1 b i ln e it 1 d ln LWW *ijt 1 m ln HP ijt 1 s ln ULC it 1 w t 1 « ijt ,
(4)
where i, j, and t are indexes for source countries, car models and time periods, respectively; p is the actual car price (i.e., retail price, measured in units of the exporter’s currency divided by the respective source country’s consumer price index); e is the exchange rate (expressed as units of the buyer’s currency per unit of the seller’s divided by the destination’s consumer price index and multiplied by the respective source country’s consumer price index); LWW* represents the selected characteristics of car models (i.e., L 3 W 3 W*, length, width, and weight); HP is the horsepower; ULC is the unit labor cost (defined as the ratio of labor cost to labor productivity, and is expressed in each respective source country’s currency deflated by the corresponding consumer price index); w represents the time dummies. The error term, «ijt, is assumed to be independently and identically distributed. (The definitions and sources of the variables are also provided in the Appendix.) The interpretation of b is derived from Knetter (1995). A value of b equal to zero means that the markup to a particular destination is independent of fluctuations in the value of the seller’s currency against the buyer’s. This implies that changes in currency values are fully passed through to the buyer. A value of b equal to zero also implies that
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demand schedules have constant elasticity with respect to price when the exporter is a monopolist. Negative values of b indicate that markup adjustment is associated with stabilization of local currency prices. A value of 20.5, for example, implies that in response to a 10% depreciation or appreciation of the buyer’s own currency, the markup would be increased or reduced by 5%. In other words, the price paid in unit of the buyer’s currency would rise or fall by only 5% (given constant costs). Negative values of b also imply that when the exporter is a monopolist, demand is less convex than a constant elasticity demand schedule. In the absence of quantity adjustment, one would expect to observe complete price stability in local currency units, i.e., a b of minus one. (As quantity adjustment takes place, prices in local currency units change and the value of b would also adjust towards zero.) Positive values of b imply that destination-specific markups change in a way which amplifies the effect of destination-specific exchange-rate changes on the price in terms of the buyer’s currency.
V. Estimation Results The estimates of coefficients derived by pooling the data for all the source countries are presented in Table 2. In order to evaluate the robustness of the results, different specifications of model (4) were tested to expose the effects of including or excluding variables. First, the model was estimated without time dummies. Second, the model was tested by a simple time trend variable (a dummy variable) in order to investigate if there was any time trend in the data. Third, the model was estimated by a set of time dummies. Finally, it was of interest to split up the LWW* variable to see whether the coefficients of exchange rates were affected. Most of the exchange rate coefficients revealed strong evidence of pricing to market and were statistically significant at conventional levels. Negative values of exchange rate coefficients imply that there is a very strong tendency to stabilize foreign currency prices in the car industry. For the Japanese, British, Italian, and German car exporters, the results are consistent with the price stabilization in local currency terms, e.g., a coefficient of 20.6 in the case of Japanese firms implies that a 10% depreciation of the SEK would result in an increase of the markup of Japanese firms in the Swedish car market by 6%. For the French car exporters, the price adjustment pattern was very different in character. Zero values of the exchange rate coefficients imply that the markup adjustment associated with exchange rate changes was unresponsive to fluctuations in the seller’s currency against the buyer’s. This is in stark contrast to the Italian, German, British, and Japanese car exporters’ behavior. The magnitude of the estimated coefficients and the implied fluctuations in actual prices suggest that Japan, Britain, Italy, and Germany had much larger profit margins than France for average levels of the exchange rate. The characteristics of vehicle types exhibited expected signs and were statistically significant at conventional levels in specifications 1–3, as indicated by Table 2. This implies that quality dimension is important in determining actual car prices. Specification (4) indicates that the length variable had a negative and significant coefficient, and the width variable was not significant, both of which were unexpected. These may be due to collinearity with other characteristics or misspecification of the equation. Unit labor costs showed expected signs and was statistically significant at conventional levels, as indicated by Table 2. This means that actual car prices are highly dependent on unit labor costs as a direct measure of a significant component of a firm’s marginal costs.
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Table 2. Estimates of Actual Price Adjustment Dependent Variable: ln pijt Variables/Specifications
(1)
Intercept
0.100 (0.87) 0.693 (24.47) 0.494 (14.90)
ln HPijt ln LWW*ijt
(2) 0.223 (1.01) 0.692 (24.42) 0.496 (14.89)
(3)
(4)
20.268 (21.11) 0.685 (24.45) 0.507 (15.37)
20.930 (20.81) 0.601 (22.58)
0.318 (12.31)
0.280 (4.39)
0.448 (6.39)
21.680 (29.72) 0.246 (0.78) 1.575 (18.60) 0.425 (6.56)
20.732 (232.74) 20.627 (229.12) 20.661 (224.43) 20.595 (211.77) 0.021 (1.46)
20.763 (214.75) 20.649 (215.97) 20.700 (210.73) 20.637 (27.80) 0.021 (1.50) 0.004 (0.66)
20.632 (211.23) 20.550 (212.32) 20.532 (27.47) 20.438 (24.80) 0.002 (0.11)
20.653 (212.56) 20.595 (214.41) 20.547 (28.31) 20.436 (25.18) 0.001 (0.04)
20.085 (22.38) 20.112 (22.81) 20.116 (22.61) 20.183 (23.55) 20.160 (23.10) 20.236 (24.00) 20.211 (23.17) 20.149 (22.20) 20.107 (21.61) 0.99 0.066 1245
20.082 (22.49) 20.089 (22.41) 20.094 (22.28) 20.168 (23.52) 20.149 (23.10) 20.212 (23.87) 20.191 (23.11) 20.124 (21.97) 20.083 (21.35) 0.99 0.056 1245
ln Lijt ln Wijt ln W*ijt ln ULCit Exporter-Specific Exchange Rates (ln eit): Japan Britain Italy Germany France Time trend Time Dummies (wt): D–77 D–78 D–79 D–80 D–81 D–82 D–83 D–84 D–85 R# 2 MSE n
0.99 0.067 1245
Note: Figures in parentheses are t values.
0.99 0.067 1245
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Aside from the negative sign on length variable, the results appear to be insensitive to the alternative specifications.
VI. Conclusions This paper examined the pricing policy of foreign car manufacturers in the Swedish market in order to reveal the degree of pass-through of exchange-rate fluctuations to the consumer price paid in Sweden. The model was designed to compare the extent of pricing to market of car manufacturers by disclosing the impact of differences in the supply source on the elasticity of the domestic price of imported cars to changes in the bilateral rate of exchange rates. The results reveal that actual car price adjustments in the car industry were responsive to changes in exchange rates, costs, and quality. The estimated values of the exchange rate coefficients implied that pricing to market behavior was more pronounced in Japanese export pricing than for British, Italian, and German exports. Adjustments were undertaken to stabilize local currency prices. The results also indicate that French prices were insensitive to exchange-rate fluctuations. The quality dimension and unit labor cost, which provided a direct measure of a significant component of firms’ marginal costs, were important in determining actual car prices.
I would like to thank Lennart Hjalmarsson, Niklas Karlsson, Bo Walfridson, an anonymous referee, and editors ¨ rebro is acknowlof the Journal for comments on a previous draft. Financial support from the University of O edged. Remaining errors and ambiguities are my responsibility.
Appendix Definition of Variables and Data Sources pijt: Actual car prices (retail prices), converted to respective exporter’s currency by exchange rates and divided by respective source country’s CPI. Sources: Alla Bilar (1976 –1985), Stockholm; Jan Ullens Bilfakta (1976 –1985), Stockholm; International Financial Statistics (various issues), Washington DC; Swedish Employers’ Confederation (1987), Wages and Total Labour Costs for Workers: International Survey, Stockholm. eit: Exchange rates, defined as destination market currency per unit of the exporter’s currency divided by the destination’s CPI and multiplied by each respective sourcecountry’s CPI. Source: International Financial Statistics (various issues), Washington DC; International Monetary Fund (various issues), Washington DC; Swedish Employers’ Confederation (1987), Wages and Total Labour Costs for Workers: International Survey, Stockholm. HPijt: Horsepower. Sources: Alla Bilar (1976 –1985), Stockholm; Jan Ullens Bilfakta (1976 –1985), Stockholm. (L 3 W 3 W*)ijt: Length (m), width (m), and weight (tons). Sources: Alla Bilar (1976–1985), Stockholm; Jan Ullens Bilfakta (1976–1985), Stockholm.
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ULCit: Unit labor cost, i.e., the ratio of labor cost to labor productivity. The former was measured per working hour at the four-digit car industry level (ISIC 3843). Labor costs were given in SEK and converted to respective exporter currencies, then deflated by each respective source-country’s CPI. Labor productivity is the production of car per hour. It was measured as the production of cars divided by the number of hours worked in the manufacturing of transport equipment (ISIC, 384). Sources: Industrial Statistics Yearbook, Vol. 1, United Nations (various issues), New York; International Labor Office (various issues), Geneva; Swedish Employers’ Confederation (1987), Wages and Total Labour Costs for Workers: International Survey, Stockholm; Yearbook of Labor Statistics (various issues), Geneva.
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