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AN ECONOMIC ANALYSIS OF NORTH AMERICAN PULP AND
PAPER MARKETS, AND A COMPETITIVENESS STUDY OF THE
CANADIAN PULP AND PAPER PRODUCTS
By
Xiaoli Tang
A Thesis Submitted in Conformity with the Requirements
for the Degree of Doctor of Philosophy
Faculty of Forestry
University of Toronto
© Copyright by Xiaoli Tang 2008
ii
AN ECONOMIC ANALYSIS OF NORTH AMERICAN PULP AND PAPER
MARKETS, AND A COMPETITIVENESS STUDY OF THE CANADIAN PULP AND
PAPER PRODUCTS
Doctor of Philosophy, 2008
Xiaoli Tang
Faculty of Forestry, University of Toronto
ABSTRACT
North America is the world’s largest pulp and paper producing region as well as the largest
consuming region. An understanding of market integration is critical for designing relevant
policies since it is important to improve national welfare and ensure long-run competitive
market equilibrium. In addition, it is crucial for the Canadian industry to maintain the
competitiveness for its pulp and paper products in the world market, because any deterioration
in the performance of the Canadian pulp and paper industry will have negative social and
economic impact on the well-being of Canada and affect Canadian balance of payment. This
thesis contains three essays that investigate the market integration of the combined markets of
Canada and the US, and the competitive position of Canadian pulp and paper products in the
US market.
The first essay presents an econometric analysis of spatial integration of the US and Canada
newsprint markets as reflected in newsprint prices. It applies the Johansen multivariate
cointegration procedure to test the law of one price for five regional markets (British
Columbia, Ontario, Quebec, US east, US west) of newsprint using monthly data for the 1988
to 2004 period. Preliminary data analysis shows that all price series are non-stationary I(1)
processes. The hypothesis that the Law of One Price (LOP) holds for all five regional
newsprint markets simultaneously was not supported by the Johansen multivariate test. The
iii
LOP was also tested for national markets, and it was found to hold between US west and US
east newsprint prices. The results suggest that there is a single newsprint market in the US,
whereas there are several distinct newsprint markets in Canada.
The second essay examines the degree of market integration among US import markets for
three pulp and paper products, and further analyses the dynamic interaction between US
domestic and US import markets. Persistence profile results show that long-run equilibrium
exists in the US import markets for three pulp and paper products of interest; moreover, given
a system-wide shock, a new equilibrium could be reached in a relatively short period. Forecast
error variance decomposition suggests that US markets are critical since shocks to domestic
US prices for relevant pulp and paper products explain a substantial amount of movements in
import prices.
The third essay studies substitution between main categories of imported pulp and paper
products and between imported and domestic pulp and paper products in the US market. A
restricted translog subcost function approach was employed to derive the elasticity of
substitution. The results suggest that Canadian pulp and paper products are still competitive
and have maintained their competitiveness in the US market. However the consecutive
demand decline for pulp and paper in the US has brought hard times to Canada. It seems that
if Canadian pulp and paper industry wants to retain a dominant position in the world market
place, it will have to create global reach and develop new markets.
iv
ACKNOWLEDGEMENTS
Early in the process of completing this project, it became quite clear to me that a researcher
cannot complete a Ph.D. thesis alone. Although the list of individuals I wish to thank extends
beyond the limits of this format, I would like to thank the following persons for their
dedication, prayers, and support:
My primary supervisors, Dr.Susanna Laaksonen-Craig and Dr. Shashi Kant, have been a
significant presence in my life. Their ability to probe beneath the text is a true gift, and their
insights have strengthened this study significantly. Without their common-sense, knowledge,
perceptiveness and persistent support I would never have finished my PhD thesis. I will
always be thankful for their wisdom and deep concern for me. It has been an honor to work
with them.
I am unable to express my gratitude in words to Dr. David Balsillie and Dr. Tat Smith for their
support and encouragement. In particular, I appreciate Dr. Tat Smith for his continued
invaluable suggestions during my career development. In this I would also like to include my
gratitude to other professors of the Department of Economics and the Faculty of Forestry for
their academic advice. In addition, I am grateful to my colleagues at our lab that have
provided the environment for sharing their experiences about the problem issues involved as
well as participated in stimulating team exercises developing in-depth discussion to the
identified problems.
Financial support from the Sustainable Forest Management Network, Wallace A. Delahey
Fellowship (2006), and Louie J Nozzolillo Fellowship (2005) is gratefully acknowledged.
Finally I want to thank my family. The encouragement and support from my husband Zheng He and our always positive and joyful son Dawei is a powerful source of inspiration and energy. A special thought is devoted to my parents for a never-ending support.
v
TABLE OF CONTENTS
Page ABSTRACT ii
ACKNOWLEDGEMENTS iv
TABLE OF CONTENTS v
LIST OF TABLES vii
LIST OF FIGURES ix
CHAPTER
I INTRODUCTION 1
II THE LAW OF ONE PRICE IN THE UNITED STATES AND CANADIAN
NEWSPRINT MARKETS 8
2.1 Introduction 8
2.2 Theoretical Background 10
2.2.1 Literature review 10 2.2.2 The LOP and cointegration 12 2.2.3 Johansen multivariate cointegration analysis 14 2.2.4 Speed of adjustment and weak exogeneity 16
2.3 Data 17
2.4 Empirical Results 20
2.7 Discussion and Conclusions 26
III ASSESSING MARKET LINKAGES: EVIDENCE FROM US IMPORTS OF
PULP AND PAPER PRODUCTS 29
3.1 Introduction 29
3.2 Theoretical Framework 33
vi
3.2.1 Approaches to cointegration and short-run dynamics 33 3.2.2 Degree of integration: persistence profiles 33 3.2.3 Generalized forecast error variance decomposition 36
3.3 Data 37
3.4 Empirical Results and Discussion 42
3.4.1. Order of integration: unit root tests and tests of multivariate cointegration 42
3.4.2 Speed of adjustment: persistence profiles 47 3.4.3 Causality tests: generalized forecast error variance decomposition
3.5 Conclusions 52
IV MEASURING THE COMPETITIVENESS OF CANADIAN PULP AND
PAPER PRODUCTS IN THE US MARKET 55
4.1 Introduction 55
4.2 Theoretical Framework 58
4.2.1 Demand for aggregate inputs 59 4.2.2 The demand for pulp/paper input components 60
4.2.3 Elasticity of substitution/price elasticity of demand 61 4.2.4 Imposing concavity 63
4.3 Estimation 64
4.4 Data 65
4.5 Empirical Results 68
4.5.1 Parameter estimates 69 4.5.2 Elasticity of substitution 70 4.5.23 Price elasticity of demand 77
4.6 Discussion 79
V CONCLUSIONS AND POLICY IMPLICATIONS 83
5.1 General Conclusions 83
5.2 Policy Implications 85
5.3 Suggestions for Future Research 87
LITERATURE CITED 88
vii
LIST OF TABLES
TABLE Page 2.1 Descriptive statistics of US and Canada newsprint prices, Jan. 1988 – 19
Dec. 2004
2.2 Augmented Dickey-Fuller (ADF) unit root test results for prices of 21 newsprint (in CAD)
2.3 VEC Multivariate Diagnostic Tests 22
2.4 Misspecification tests for residuals from Johansen’s cointegration 23 estimation of model [2.4] with 4 lags
2.5 Results for co-integration tests for Canadian and US markets 23
2.6 Results of co-integration tests for newsprint in Canadian markets 24 (BC, ON, and Quebec)
2.7 Results of co-integration tests for newsprint in US markets 24
(US west & US east)
2.8 Normalized eigenvectors, β1, and their weights, α1, obtained from 25 cointegration estimation of model (2.4)
2.9 Test results for the LOP by pairs of prices obtained from model (2.4) 25 by restricting β1 under r=1
2.10 Test results for weak exogeneity of newsprint prices in the North 26 American markets
3.1 Augmented Dickey-Fuller (ADF) unit root test results 45 3.2 Misspecification tests for residuals from Johansen’s cointegration 47
estimation of model (3.1)
3.3 The results of cointegration rank tests 48
viii
3.4 Generalized forecast error variance decomposition for LWC: Period 10 50
3.5 Generalized forecast error variance decomposition for BHKP: Period 10 51
3.6 Generalized forecast error variance decomposition for Kraftpaper: Period 10 51
4.1 Summary statistics of real unit value (1982=100) and cost shares for pulp 68 and paper products in the US market, January 1999 – July 2007
4.2 Parameter estimates of the Translog Cost Function for Newsprint, among 70
Canada, US, and the rest of other countries, Jan. 1999 – July 2007 4.3 Parameter estimates of the Translog Cost Function for BHKP, among Canada, 71
Brazil, and the rest of other countries, Jan. 1999 – July 2007 4.4 Parameter estimates of the Translog Cost Function for LWC, among US, 72
Canada, and the rest of other countries, Jan. 1999 – July 2007 4.5 The estimated Allen and Morishima elasticities for BHKP, Jan. 1999 to 73
July 2007 4.6 The estimated Allen and Morishima elasticities for newsprint, Jan. 1999 74
to July 2007
4.7 The estimated Allen and Morishima elasticities for LWC, Jan. 1999 to 77 July 2007
4.8 Own- and cross-price elasticities of demand for pulp and paper products, 78 US, Jan. 1999 to July 2007
ix
LIST OF FIGURES
FIGURE Page 2.1 Canadian newsprint production, exports and domestic sales, 1996-2004 18
2.2 Real prices of newsprint export (in logs) from British Columbia, Ontario, 20 and Quebec to the United States, Jan.1998-Dec.2004
2.3 Real prices of newsprint (in logs) in US east and US west, January 1998 – 21 December 2004 3.1 US imports of LWC by quantities, 1989-2006 38 3.2 US imports of BHKP by quantities, 1989-2006 39
3.3 LWC imports (real unit value in logs) from Canada, Finland, and Germany 40 to the USA, and domestic US price (real price in logs), 1989:01–2006:12
3.4 Imports of BHKP (real unit value in logs) from Canada and Brazil to the 41
US, and domestic US price (real price in logs), 1989:12 – 2006:12 3.5 Kraftpaper imports (real unit value in log) from Canada and Germany to 41
the US, and domestic US price (real price in logs), 1989 (first quarter) –2006 (forth quarter)
3.6 Prices series for LWC, by level and first difference, respectively 42
3.7 Prices series for BHKP, by level and first difference, respectively 43
3.8 Prices series for Kraftpaper, by level and first difference, respectively 44
3.9 LWC: Persistence profile of the effect of a system-wide shock 49
3.10 BHKP: Persistence profile of the effect of a system-wide shock 49
3.11 Kraftpaper: Persistence profile of the effect of a system-wide shock 49
4.1 Shares of Newsprint by country to total Newsprint consumption in 65 the US
4.2 Shares of BHKP by country to total US imports 66
4.3 Shares of LWC by country to total LWC consumption in the US 67
x
4.4 MES between US and Canadian newsprint, 1999 – 2001 75
4.5 Apparent consumption of newsprint in the US market 76
4.6 MES change for Canadian BHKP, 1999 – 2001 73
4.7 MES between US and Canadian LWC, 1999 – 2001 77
1
CHAPTER I
INTRODUCTION
Markets aggregate demand and supply across actors distributed in space, and play a
fundamental role in managing risk associated with demand and supply shocks. Studies on
market structure and market linkages can provide a strong base of information to the
government before it launches a new strategic initiative or setting new strategic goals. To
define the market, economists believe it is market prices that have held center stage (e.g.,
Cournot, 1972; Marshall 1930, and Stiglize, 1993). Price transmits information about
changing demand and supply conditions to buyers and sellers, and widening price-cost
margins signal profit opportunities to which alert entrepreneurs respond. In addition,
economists argue that well-integrated markets can facilitate adjustment in net export flows
across spaces, thereby reducing price variability faced by customers and producers. At the
international level, monetary policy, exchange rate adjustment and the distribution of the
gains from trade depend fundamentally on how well prices equilibrate across countries. At
the national level, macroeconomic policy commonly becomes ineffective without strong
market transmission across space of signals sent by governments. Therefore delineating the
boundaries of markets have been of interest to academics and policy makers. For example,
the Uruguay Round of the General Agreement on Tariffs and Trade (GATT) was believed to
reduce tariffs and non-tariff barriers over the next decades. Moreover, commercial blocks like
EU and NAFTA are also developed for more integrated markets.
The opening of markets and increased competition makes it impossible for companies to
isolate themselves from international factors. A firm’s market share in a given export will
increase or decrease, depending on the price of its product relative to those of its competitors.
Moreover, its competitive position is determined by relative costs and the elasticity of
demand for its products. If any of the factors that determine relative costs changes, exporters
2
either change the delivered price, or maintain the price and absorb the resulting reduction in
profit.
Pulp and paper are two of the most commonly traded commodities in global market. The
North American market for pulp and paper products is of special interest to study due to its
global significance as both the largest producing region and the largest consuming region in
the world. In particular, Canada ranks second to the United States in pulp and paper
manufacture and first in pulp and paper exports (PPPC, 2005). One of the goals of NAFTA
and sustainable forestry is to develop an integrated market for forest products (USDC 2003).
Considering the value of pulp and paper traded in the North American market, it is crucial to
understand its market behavior, since the changes in the North America market may have
important implications to world pulp and paper markets.
Meanwhile, globalization has obliged all countries to raise their standards of economic
efficiency. This is a growing interest and concern in the Canadian forest industry. It is crucial
for the Canadian pulp and paper industry to maintain its competitiveness in the world market.
As the largest industry in Canada and an export-focused industry, any deterioration in its
performance will have negative social and economic impact on the well-being of Canada and
affect its balance of payment. The pulp and paper industry is capital intensive and is
characterized by strong competition as well as evolving demand. In the past decade,
competition within global pulp and paper industries increased dramatically, as the number of
countries exporting pulp and paper products increased. The Canadian pulp and paper industry
does not escape this global context. There were closures of Canadian newsprint mills and
pulp mills for the past years. Maximizing returns in this industry is a complex task and
international factors such as exchange rates, income taxes, access to resources and trade
regulations may have a very significant impact on company performance.
The relationship between the market structure of the forest industry and price has been
studied extensively. In terms of the pulp and paper industry, some scholars focus on the
market power (Pearse 1976; Singh and Nautiyal 1984; Schembri and Robicheau 1986;
Townsend and Uhler 1986) of the Canadian industry, while others studied the factors
3
affecting the demand for Canadian pulp and paper products (Ghebremichael 1989; Baker
1991; Jee and Yu 2001). However, few studies have tried to verify whether there is a single
and integrated market for pulp and paper products in North America1, in other words,
whether there exists a long-run equilibrium among different pulp and paper markets in North
America. This is a basic condition that guarantees no arbitrage opportunities and is necessary
for spatial price parity.
In modeling and forecasting the demand for and trade of forest products, it would be useful to
have direct tests for the existence of the law of one price (LOP). The theory of LOP suggests
that efficient trade and arbitrage activities will ensure that prices for a homogenous
commodity in geographically dispersed markets will be equalized such that spatial price
differentials are always less than or equal to transaction costs. For example if LOP holds for
North American pulp and paper markets, there is a single price for homogenous pulp and
paper products across Canada and the US. However, it does not mean exactly the prices are
the same for identical products in different markets, since LOP allows price differences
derived from transaction costs. Rather, it means that prices expressed in common currency do
not deviate permanently from each other. In other words, there exists long-run equilibrium
among the markets.
It is crucial to understand how market and prices are interrelated. In the market where LOP
holds, some prices may still be driving forces behind the other prices. Price-leading markets
play a dominant role in establishing the long-run equilibrium relationship in international
trade. Dominant price trends are useful for forecasting prices and will be an important
indicator of the demand from central market, since any policy intervention targeted at these 1 There are few studies about market integration for P&P in Europe, including Kainulainen and Toppinen (2006), Ha¨nninen et al. (1997), and Vataja (1999). Kainulainen and Toppinen (2006) studied three European markets, i.e., France, Germany, and UK, for two paper grades: light-weight coated (LWC, 60 g/m2) paper and uncoated wood-free office paper (80 g/m2) in Euros per ton. Their results indicate that the extent of market integration had slightly strengthened after the introduction of European currency union. Ha¨nninen et al. (1997) have found the law to hold between Swedish and Canadian newsprint import prices in the UK market, while the law was rejected between Finland and Sweden in the UK and Germany. Vataja (1999) found evidence for the law between Finnish and Swedish newsprint export prices. As to Asian pulp and paper markets, there seems no specific study on the market integration.
4
locations would be automatically transmitted to the rest of the locations of the integrated
market. A study on the degree of market integration can shed some light on what happens if a
random shock hits its long-run equilibrium relationship, and how fast the system returns to
the equilibrium state. In addition, there are reasons to expect a relationship between US
domestic prices and import prices, considering the US is the world’s largest consumer and
producer for pulp and paper products (FAO 2006). The changes in the US market are likely
to have important implications for global pulp and paper markets, particularly to the
Canadian pulp and paper industry, which heavily relies on the US market. There is hardly any
study which has examined price-leading markets and the degree of market integration, both
of which are associated with the concept of law of one price in the context of North America
pulp and paper markets.
The degree of integration is defined as the reaction time required for removing disequilibrium
among spatially separated markets. The higher degree of market linkage, the faster the co-
integrated series will converge. Thus, the speed of convergence can measure the degree of
market linkage. In the forest sector the long-run market structure for different forest products
has been studied extensively, while few topics have attracted as much attention and
controversy as the topic of convergence to the long-run equilibrium, and only few studies
have tried to assess the degree of market integration. An estimate of the convergence speed
improves the understanding of the informational efficiency beyond the simple
acknowledgement of the long-run relationship (Pesaran and Shin, 1996), since in the
convergence process, the adjustment to and the incorporation of new information are the
primary determinants of the length of time necessary for convergence to occur. In addition to
assessing the degree of market integration, I also seek to provide further information on how
shocks to the US price series explain fluctuations in other import price series, i.e., how the
US market behaves as a price leading market.
The ability of an export dependent industry to maintain its social and economic contributions
depends, to a large extent, on its success in maintaining and improving its competitiveness in
the world market. There are different approaches to study international competitiveness. For
5
example, the change in a country’s share in world exports is a direct manifestation of
competitiveness. In addition, much can be learned about competitiveness from comparisons
of prices and price movement. It has been suggested, however, that costs are a better focus
for the study of international competition than prices (Stern, 1962; Stern and Zupnick, 1962).
In general, the higher the elasticity of substitution between one country’s products and
another’s, the more completely buyers shift from one to the other in response to small relative
price changes. Therefore cost conditions can be reflected in relative prices and price changes.
Most existing econometric studies of pulp and paper industry examine the growth of
productivity within a specific country, and with a focus on factor substitution among input
factors, from the supply side. None of those studies compare the competitiveness of pulp and
paper products among different suppliers and address substitution from the demand side.
Economists have developed models to examine the substitutability from the demand side
(Christensen et al., 1971; Fuss 1977). Those models have been used in international trade of
wood products (Nagubadi et al., 2004; Uusivuori and Kuuluvaninen 2001; Vincent et al.,
1990; Vincent et al., 1991), but no study has tested the substitution of internationally traded
pulp and paper products.
This research attempts to fill these gaps in the literature of economic analysis of pulp and
paper products in North America. The main objectives of this research are: i) to test
cointegration of prices among North American pulp and paper markets; ii) to examine the
degree of market integration, and further examine the causality between the domestic and
import markets in the US; and iii) to provide an assessment of the competitiveness for pulp
and paper products in the US market.
There exists a wide range of pulp and paper products that can be aggregated into three
distinct families: market pulp, paperboard, and paper. Paper is further subdivided into four
products as newsprint, printing and writing paper, paperboard and tissue. The following
products are selected for this study: 1) newsprint, 2) chemical wood pulp, soda or sulfate,
nonconiferous (Harmonized System Code, or HS Code, 470329), called “BHKP” in the rest
of this paper, 3) light-weight coated paper (HS Code 481021), called “LWC” in the rest of
6
this paper, 4) kraft paper and paperboard (HS Code 481029), called “Kraftpaper” in the rest
of this paper. Those products are mostly traded pulp and paper in North America, and the
study of their market behavior is indicative of the development of the pulp and paper
industry.
A comprehensive economic analysis of pulp and paper products can be done by ascertaining
the behavior of prices among North American markets to address each of the three specific
objectives. Accordingly, the studies conducted in this research have been divided into three
distinct essays. Each of the essays provides specific information about the existing
relationship between North American pulp and paper markets based on an analysis of prices
or prices and production costs. The first paper2 presents an econometric analysis of spatial
integration of the United States and Canadian newsprint markets as reflected in newsprint
prices. Cointegration tests are conducted among different combinations of the regional
markets of the two countries. The speed of adjustment is also examined. The second paper3
examines the degree of market integration among US import markets for three pulp and paper
products, and further analyses the dynamic interaction between US domestic and import
markets. Persistence profiles are used to assess the degree of market integration among the
markets, and forecast error variance decomposition to further gauge the information
transmission pattern between the US domestic and import markets. In the third paper4, I
applied the subcost function approach to examine the substitutability of three categories of
pulp and paper products in the US market. The literature review and details of empirical
models of each section are included in each essay. Each paper is self-contained, that is, it has
its own introduction, methodology, data description, results and conclusion.
This dissertation is organized as follows. Chapter II contains the first article, entitled “The
Law of One Price in the United States and Canadian Newsprint Markets”. Chapter III
contains the second paper, entitled “Assessing market linkages: evidence from US imports of
pulp and paper products”. The third paper is in chapter IV, and is titled “Measuring the 2 This paper was published in Canadian Journal of Forest Research, volume 37, 2007. 3 This paper was submitted to Forest Science in October 2007. 4 This paper was submitted to Canadian Journal of Forest Research in May 2008.
7
Competitiveness of Canadian Pulp and Paper Products in the US Market”. Lastly, Chapter V
covers the summary and conclusion, policy implications of the results, limitations and
suggestions for future research.
8
CHAPTER II
THE LAW OF ONE PRICE IN THE UNITED STATES AND CANADIAN
NEWSPRINT MARKETS
2.1 Introduction
North America is the largest pulp and paper producing region, accounting for over one third
of world newsprint capacity, and nearly one third of world demand (NPA, 2005). In Canada,
the pulp and paper industry is the largest manufacturing industry, providing 56,300 jobs in
year 2003 (PPPC, 2005). Canada ranks second to the United States in pulp and paper
manufacture, and first in pulp and paper exports. The US is the world’s largest newsprint
market with an apparent consumption of 9.9 million tons and production of 5.1 million tons
in 2004, whereas Canada is the world’s largest producer and exporter of newsprint, 8.2
million tons and 7 million tons in 2004, respectively. Canada’s main export market is the US,
which absorbed about 60% of Canadian newsprint in 2004. (NPA, 2005) Quebec, Ontario
and British Columbia are the three major supplier provinces and the newsprint from these
three provinces accounted for 80% of total Canadian newsprint exports in 2004 (Industry
Canada, 2005). In terms of imports, Canada is the principal supplier of newsprint in the
United States and during the late 1990s, the Canadian newsprint accounted for over 90 per
cent of total US newsprint imports (USITC, 2000). Though the percentage share has fallen in
recent years, the majority of US newsprint imports still originate from Canada.
One of the goals of the North American Free Trade Agreement and sustainable forestry is to
develop an integrated market for forest products, i.e., to have only one single regional market
instead of many separate markets (USUDC, 2003). Compared to other forest products,
9
newsprint market in North America has had minimal trade barriers, and for many years
imports of newsprint have entered the United States free of duty. Unlike softwood lumber
trade between U.S. and Canada, which has been in the center of the most contentious trade
dispute between the United States and Canada (Lindsey et al. 2000), U.S. imports of
newsprint are not subject to quotas, embargoes, or other non-tariff barriers (USITC, 2000).
Due to the trade dispute, the softwood lumber markets have been studied extensively.
However, considering the value of newsprint trade between Canada and the US, it is also
crucial to understand the behavior of Canadian and the US newsprint markets. The newsprint
imports and exports not only have a significant impact on both American and Canadian
producers, the changes in the North American market are likely to have important
implications for the global newsprint markets. Despite the significance of the market, there
are only a few studies concerning newsprint markets and market structure, and there are no
previous studies that have specifically looked at the market integration in North American
newsprint markets.
The previous research on pulp and paper industry has mainly examined pulp markets, and it
has indicated that Canadian pulp producers may have significant market power in the
international market (Pearse, 1976; Singh and Nautiyal, 1984; Schembri and Robicheau,
1986). However, Townsend and Uhler (1986) found only weak evidence of market power for
Canadian pulp producers and they were expected to face stiff competition in the international
market. Alavalapati et al. (1997) studied Canadian wood pulp trade with the US, and their
findings provide little evidence of market power for Canadian pulp exporters. There are a few
studies regarding lumber indicating that a single national softwood lumber market exists in
the United States (Uri and Boyd, 1990; Jung and Doroodian, 1994; Yin and Baek, 2005),
while in Canada there seems to be a series of geographically distinct markets (Nanang, 2000).
In a recent study on North American softwood lumber market, Shahi et al. (2006) find that
there is not a single market in North America for aggregate softwood lumber market.
10
Previous studies regarding the newsprint markets in North America have utilized models
based on oligopolistic market structure with dominant firm price leadership (e.g., Dagenais
1976; Booth et al., 1991). Additionally, only a few studies have analyzed North American
newsprint markets using recent data. For example, Ghebremichael (1989) used data from
1966 to 1986 to analyze the demand for newsprint exported to the US from Ontario, whereas
Baker (1991) analyzed data from the period of 1966 to 1987 to study the US demand for
Canadian newsprint. One of the most recent studies on US demand for Canadian newsprint is
by Jee and Yu (2001), who used data from 1988 to 1996.
The structure of markets can be understood by studying integration of markets using price
analysis. If markets are not integrated, perfectly competitive conditions may not hold between
segmented markets (Nagubadi et al. 2001). The present study tests the “law of one price”,
i.e., if the prices of a particular commodity in various international markets are equalized
when expressed in the same currency, in the US and Canada markets among the main
supplier provinces/regions, by using Johansen’s multivariate cointegration analysis. Monthly
data from January 1988 to December 2004 is employed.
The study is organized as follows. After the literature review, the outline for the testing
procedure of LOP is described, followed by the data section and empirical results. Discussion
and conclusions are presented in the final section.
2.2 Theoretical background
2.2.1 Literature review
The relationship between the market structure of an industry and the price has been studied
extensively (Dunn 1970; Dornbusch 1987). Perfect competition has been assumed in a
number of studies that model forest product markets and trade (e.g., Adams and Haynes
1980; Dykstra and Kallio 1987; Brännlund et al. 1982), but imperfect competition has also
been utilized in several studies (e.g., Armington 1969; Chou and Buongiorno 1983; Blanter
1989; Dagenais 1976; Laaksonen et al. 1997) allowing for price differences across markets.
11
As to the newsprint market, both perfect and imperfect competition have been assumed, and
there is no consensus which one is superior in modeling this market (Hänninen et al. 1997).
In modeling and forecasting the demand for and trade of forest products, it would be useful to
have direct tests for the existence of the law of one price (LOP). The LOP assumes perfect
competition in the market, and it is a commonly used assumption in modeling commodity
trade. Markets are integrated if, at equilibrium, the law of one price holds and no arbitrage
opportunity exists as a necessary condition for spatial price efficiency. The analysis of market
starts by determining if the markets are cross efficient, i.e., is it possible to profit by trading
across commodity markets by exploiting price movements in one market to predict price
movement in another. Gonzalez-Rivera and Helfand (2001) proposed a definition of market
integration on two related dimensions: trade and information. They argued that for a market
to be called integrated, the set of locations should share the same traded commodity and the
same long-run information. If the markets are not well integrated spatially, regional or
national aggregation may lose much of the information specific to individual markets. The
inferences and conclusions drawn from the analysis of such aggregated markets may not be
valid (Nagubadi et al. 2001). According to Baulch (1997), markets are integrated if prices in
different markets move together and their price differential equals the transfer costs that
include transportation and transaction costs. If there is an equilibrium relationship between
two markets, the prices in these markets cannot diverge by more than a small amount in the
long-run (Engle & Granger 1987). In most forestry literature, the common approach for
testing the LOP is the test of cointegration between different price series using a bivariate
Dickey-Fuller procedure (e.g., Buongiorno and Uusivuori 1992) and/or Johansen multivariate
co-integration test (e.g., Hänninen 1997; Yin et al. 2002).
Recently cointegration analysis has become a widely used technique for analyzing economic
time series data. Cointegration techniques are necessary because of the nonstationary nature
of many economic time series. Failure to account for the nonstationarity of data can lead to
invalid standard statistical tests and inferences, and may result in spurious regressions (Engle
& Granger 1987). Several of previous studies on newsprint demand applied simple OLS
12
approach to the time series data. Ghebremichael (1989) estimated the demand for newsprint
exported to the US from Ontario, Canada, using ordinary least squares estimation and annual
data from 1966 to 1986. His study was criticized by Jee and Yu (2001), however, as the
cross-price elasticity of Ontario newsprint exports with US newsprint is -1.45, indicating
“hard-to-believe” complementarity. Another study on US demand for Canadian newsprint by
Baker (1991) utilized an Almost Ideal Demand System (AIDS) and data for the period of
1966 to 1987. However, only two variables, i.e., U.S. income and the U.S. import price of
Canadian newsprint, were used in the function specifying the U.S. demand for Canadian
newsprint. This exclusion of other variables may have caused biased estimates (Jee and Yu
2001).
2.2.2 The Law of One Price and cointegration
The law of one price states that in one market there is one price, i.e., once prices are
converted to a common currency, the same good should sell for the same price in different
countries. Determining the area where the LOP holds is, therefore, equivalent with
determining the size of the market, which is implied by the economic definition of market by
Stigler (1969, 1985): “the area within which a price of a good tends to uniformity, allowances
being made for transportation costs”.
Assuming no transportation cost, the LOP means that in equilibrium pit = pjt, where pit is
country i’s price of the commodity, pjt is country j’s price for the same commodity. Both
prices are expressed in the common currency, and on logarithmic form. The LOP could be
investigated empirically by estimating
pit = 1α + 1β pjt + tε (2.1)
The literature commonly operates with two different forms of the LOP, the strong version of
LOP and the weak version of LOP. Strong LOP refers to testing the hypothesis
1α = 0 and 1β = 1, where weak LOP is to test whether 1β = 1. The test is, however,
conditioned on some assumptions, for example, both series are stationary. If one of the prices
13
is stationary, i.e., I (0) process, when the other is not, then the LOP between those two prices
is rejected automatically. If both prices are I (1) process, the theory of cointegration could be
applied.
Cointegration means that there exists some long-run equilibrium relation that ties two or
more time series together, and which is represented by their linear combination (Hamilton,
1994). In the context of the LOP, cointegration implies that prices of identical products,
expressed in common currency, do not deviate permanently from each other. Thus, it is
expected that valid testing for the LOP can be done by means of cointegration analysis. In
equation (2.1), supposing that pit and pjt are integrated of order one, then the LOP is said to
hold in the long-run if the spread of the common currency prices of commodity , denoted by
zt, is a stationary process:
zt = pit – pjt = tμ ~ I (0) (2.2)
The concept of cointegration was first introduced by Granger (1981), and elaborated further
by Engle and Granger (1987). Since then, estimation and testing for cointegrating
relationships have been studied extensively, and a number of different procedures are
nowadays available. They are, chronologically, ordinary lease squares (OLS) by Engle and
Granger (1987), nonlinear least squares (NLS) by Stock (1987), principal components (PC)
by Stock and Watson (1988), canonical correlations (CC) by Bossaerts (1988), maximum
likelihood in a fully specified error correction model (MLECM) by Johansen (1988),
instrumental variables (IV) by Hansen and Phillips (1990), and spectral regression (SR) by
Phillips (1991). In this paper, we consider Johansen’s maximum likelihood procedure.
Among different procedures for integration test, Engel and Granger and Johansen method are
mostly commonly used. The Johansen-Juselius multivariate cointegration analysis offers
several advantages. It is a robust test since it considers all possible cointegration relationships,
and it provides likelihood ratio tests for the hypothesis that cointegration vectors exist.
14
2.2.3 Johansen multivariate cointegration analysis
The cointegration method of Engle and Granger (1987) has been criticized because the
cointegration is confined to pairwise comparisons which require that one of the two variables
be designated as exogenous (Nagubadi et al. 2001). Moreover, when pairs of prices are
considered separately, any linkages that may operate through a third market price are ignored.
Johansen’s (1988, 1995) maximum likelihood procedure for cointegration tests identifies
cointegration relationships in a multivariate setting. This procedure does not require that one
of the variables be designated as exogenous. In addition, in contrast to the two stage Engle –
Granger methodology, Johansen’s approach is a one-stage procedure. In Johansen’s
methodology for the multivariate cointegration test, the basic statistical model is an
unrestricted p-dimensional vector autoregressive (VAR) model of lag order k, as given
below:
xt = μ + Π1xt-1 +, … , +Πkxt-k + ΦDt + εt; t = 1, …, T (2.3)
where xt is a (p x 1) vector that denotes the tth observation on a set of p variables in levels, μ
is a (p x 1) vector of intercept terms, Πi, …, Πk are (p x p) matrices of parameters, Dt
represents a matrix of non-stochastic variables like seasonal dummies, Φ is a (p x 1) vector of
coefficients for the non-stochastic variables, k is the number of lags, and εt is a (p x 1) vector
of normally, independently and identically distributed error terms. Each endogenous variable
in the system is modeled on lagged values of itself and the other endogenous variables in the
system, which makes the VAR very flexible as it can facilitate the analysis of the system
dynamics of random variables.
According to the Granger representation theorem, the existence of cointegration implies that
an equilibrium-correction model (ECM) exists. The ECM makes it possible to distinguish
between the short-run and long-run relationship between the two time series, and investigate
these relationships empirically. Equation (2.2) could be re-parameterized in error-correction
form (e.g., Johansen 1995, P. 89) such as
15
Δxt = μ + Γ1Δxt-1 +,…,+ Γk-1Δxt-k+1 + Πxt-k + ΦDt + εt (2.4)
where Δxt is a (p x 1) vector with I(0) vector, Γ1, …, Γk-1 and Π are coefficient matrices. Γ
describes short-term dynamics of the process and Π is the matrix of long-run coefficients.
Further more, Π can be decomposed into a matrix of loading vectors, α, and a matrix of
cointegrating vectors, β, such that Π = αβ’. The VECM representation in Equation (2.4)
differs from the VAR in that the VECM is expressed in both lagged levels and differences.
This gives the model rich dynamics, as it incorporates both short-run effects given by the Γi
coefficients, and the long-run effects, which are represented by Π.
If there are p variables in the system, and matrix Π has a rank of p – 1, then we can say there
is full market integration and LOP holds for all markets simultaneously (Goodwin &
Grennes, 1994). If the rank of matrix Π is less than p – 1, the degree of market integration is
said to be lower and the hypothesis of full market integration is rejected.
The Johansen co-integration procedure involves a rank test and a parameter restriction test.
The rank test is a test of the weak version of LOP using a multivariate autoregression model.
When the number of co-integration vectors, r, has been determined by the rank test, it is
possible to further test the LOP hypothesis by imposing linear restrictions on the β-matrix to
find one-to-one relationships between the underlying series (Baffes, 1991), which is a test of
the strong version LOP.
In the LOP context, cointegrating relationships can be interpreted as market integration when
two variables exhibit β-coefficients of equal magnitude, with opposite signs. To test the
strong version of LOP, the model is usually normalized on the restricted coefficients, i.e.
unit-restrictions with opposite signs are imposed on pairs of variables, while the remaining
variables are restricted to zero. In a n x n system:
16
β’ = Hϕ =
⎥⎥⎥⎥⎥⎥
⎦
⎤
⎢⎢⎢⎢⎢⎢
⎣
⎡
−
−−
100
010001111
(2.5)
Where H is a design matrix giving the restriction on the β matrix and ϕ is a matrix of the
parameters reduced by means of H.
2.2.4 Speed of adjustment to disequilibrium and weak exogeneity
The existence of the cointegrating vector requires that any deviation from the long-run
equilibrium is corrected. In addition to providing long-run information among variables, the
Johansen procedure provides information about short-run responses of particular variables to
periods of disequilibrium in a particular cointegrating vector. In the VECM, it has been
shown that Π = αβ’, and suppose the rank of Π is r. The r linear combinations of Xt, i.e., the
cointegrating vectors, β0Xt, are often interpreted as deviations from equilibrium and α is the
matrix of adjustment or feedback coefficients, which measure how strongly the r stationary
variables β0Xt feedback onto the system. A low coefficient indicates slow adjustment and a
high efficient indicates rapid adjustment.
Often in empirical modeling of the interrelations between a set of economic variables, it is
assumed that certain variables can be considered exogenous and analysis of the variables of
interest proceeds conditional on the exogenous variables. The concept of weak exogeneity is
a statistical formulation of this idea. In the market where LOP holds, some prices may still be
driving forces behind the other prices. To test for weak exogeneity in the system as a whole
requires a test of the hypothesis that H: αij = 0 for j = 1,…,r , i.e., when all elements in row i
be restricted to zero, the corresponding variable is weakly exogeneous to the remaining
variables in the system. In the case of a n x n system where the second row is restricted:
17
⎥⎥⎥⎥⎥⎥⎥⎥⎥⎥⎥⎥
⎦
⎤
⎢⎢⎢⎢⎢⎢⎢⎢⎢⎢⎢⎢
⎣
⎡
==
nnn
n
n
H
θθ
θθ
θθ
θα
……
1
331
111
00
(2.6)
2.3 Data
Most Canadian newsprint is exported to overseas markets (fig. 2.1.), with the US as a major
importer, while the domestic market for newsprint is relatively small, only 12% of the
Canadian production was sold domestically in 2004 (PPPC, 2005). The data used in this
paper consist of unit values of newsprint exported to the US from British Columbia, Ontario,
and Quebec as proxies for Canadian prices, as well as the domestic newsprint prices of US
east and US west5. The data are monthly and seasonally unadjusted, and cover the period
from January 1988 to December 2004. The export values of newsprint to the US were
described by the average export value (CAD/ton) based on FOB figures, while the domestic
prices of newsprint, U.S. west and the U.S. east, were delivered price in domestic markets.
Utilization of the export unit values to represent Canadian newsprint prices carries an
assumption that the newsprint exported from Canada is homogeneous. The assumption seems
justified as among different paper products, newsprint is the most homogeneous grade and is
used for similar end-use (Hänninen et al. 1997). For example, around 80% of all the
newsprint consumed in North America is used for the printing of daily newspapers (NPA,
2005). As to US newsprint prices, only aggregate data, i.e., US east and US west, is available.
Yin and Baek (2005) argue that the data compilation presumed that the markets are integrated
at the regional level. However, since the newsprint demand in US west is generally met by
mills in the Western United States and British Columbia, and newsprint elsewhere generally
5 According to a report released by USDA, “United States Paper, Paperboard, and Market Pulp Capacity Trends by Process and Location, 1970-2000”, in October 2001, US west include states like OR, MT, ND, SD, WY, ID, WA, CA, NV, UT, CO, NE, KS, NM, and AZ, the rest of other states belong to US East.
18
is supplied by mills in the Southern United States and Eastern Canada (USITC, 2000), it
seems appropriate to use two US prices.
Data on export quantities and values to US from British Columbia, Ontario and Quebec were
obtained from Statistics Canada, and data on monthly newsprint prices for US east and US
west were obtained from Paperloop (www.paperloop.com). In addition, the Canadian unit
value series were deflated by Canadian monthly producer price index (Oct. 1997=100) and
the US prices were deflated by US monthly producer price index (Oct. 1997=100).
Additionally, the US prices were converted to Canadian dollars by using monthly average
CAD/USD rate obtained from the Board of Governors of the Federal Reserve System
(www.federalreserve.gov).
Descriptive statistics for all data series are reported in Table 2.1. The export unit value series
from Quebec was the least volatile and, on average, lower than the unit values from British
Columbia and Ontario. In relative terms, the price difference between Ontario and Quebec is
smaller, comparing to the price difference between Ontario and BC, and Quebec and BC. The
Fig. 2.1. Canadian newsprint production, exports and domestic sales, 1996-2004
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
1996 1997 1998 1999 2000 2001 2002 2003 2004
year
(000
s to
nnes
)
Production
Exports
Domestic sales
19
newsprint prices of British Columbia were higher than the prices from other US and other
Canadian markets. We also note that the differences of newsprint prices between the two US
areas are very small.
Graphs of US and Canada newsprint prices are presented (real price series in logarithms) in
Fig. 2.2 and Fig. 2.3, respectively. The prices and unit values in all five markets seem to
follow almost the same trend. One reason might be that the Canadian newsprint market is
relatively small, i.e., less than one eighth of its production was consumed domestically (NPA,
2005), and consequently Canada’s newsprint industry has traditionally relied heavily upon
export markets, particularly the United States. The Canadian newsprint has to respond to the
Table 2.1. Descriptive statistics of US and Canada newsprint prices (CAD/ton), Jan. 1988 – Dec.
2004
Name Mean Standard
Deviation Minimum Maximum
BC 873.31 163.1 547.22 1286.5
Ontario 950.83 117.36 771.3 1239.8
Quebec 811.11 93.553 611.65 999.71
US east 755.19 118.94 542.86 1044.5
US west 753.94 122.23 542.86 1065.4
Note: Prices are real and reported in Canadian currency.
fluctuations from the U.S. markets. The unit values of Canadian newsprint were relatively
stable, comparing with the U.S. newsprint prices, until the mid-1990s. All prices and unit
values peaked in 1995, and since then there has been a slow, somewhat cyclical decline until
the end of the research period. Price fluctuation could be based upon strength of demand,
startup of new newsprint capacity, strikes at newsprint mills, and willingness of newsprint
producers to cut production in times of excess supply.
20
2.4 Empirical results
Separate price series are cointegrated when each series is individually nonstationary, but a
linear combination of the variable is stationary (Hamilton, 1994). In order to test whether the
newsprint markets are cointegrated, I first examined if individual price series were
nonstationary. The results of the stationarity tests are reported in Table 2.2 showing the
augmented Dickey-Fuller test statistic and the optimum lag length, k. The results presented in
Table 2.2 are based on a model with a constant and a trend. We performed the test with 1 to 5
lags, and the results were found to be invariant to the use of different number of lags. In all
cases, the hypothesis that the prices had a unit root could not be rejected at 5% level. The
table also shows the ADF statistics for the first differences of the price series. The null
hypothesis of unit root is rejected for all first differences as the ADF statistics are greater than
the critical values at the 5% level. The results thus indicate that all the levels of prices are
nonstationary I(1) processes, while the first differences of prices are clearly stationary.
Fig.2.2. Real prices of newsprint export (in logs) from British Columbia, Ontario, and Quebec to the United States, Jan.1998-Dec.2004
5.8
6
6.2
6.4
6.6
6.8
7
7.2
7.4
1988 1988.1 1989.1 1990.1 1991.1 1992 1993 1993.1 1994.1 1995.1 1996.1 1997 1998 1998.1 1999.1 2000.1 2001.1 2002 2003 2003.1 2004.1
year
valu
e
BC
ON
Quebec
21
Table 2.2. Augmented Dickey-Fuller (ADF) unit root test results for prices of newsprint (in CAD)
Levels First-differenced Area
# of lagsa ADFb # of lagsa ADFb
BC 14 -1.7663 9 -3.5378*
Ontario 14 -2.0682 4 -4.3135*
Quebec 14 -2.5215 4 -4.6260*
US west 14 -1.8335 9 -3.8629*
US east 14 -1.8770 8 -3.9806* a Lag order was chosen automatically by Johansen program. b Augmented Dickey-Fuller test; in all the ADF tests a constant and a time trend were induced. * Denotes the rejection of the null hypothesis of nonstationary. The critical t-value is -3.49 at the 5% level.
The Johansen procedure was used to determine the number of cointegrating relationships in
the data by estimating the equation (2.4). To validate our model selection for cointegration
analysis, we conducted diagnostic tests for the residuals of our data with different lag lengths.
These tests include serial correlation, heteroskedasticity, and normality. Overall, it appears
that the model with four lags describes the data well. Summary of the diagnostic tests for the
Fig. 2.3 Real prices of newsprint (in logs) in US east and US west, January 1998 – December 2004
5.8
6
6.2
6.4
6.6
6.8
7
7.2
1988 1988 1989 1990 1991 1992 1993 1993 1994 1995 1996 1997 1998 1998 1999 2000 2001 2002 2003 2003 2004
year
valu
e
USwestUSeast
22
whole multivariate system indicates a well specified stable model (see Table 2.3). Though the
null hypothesis of normality was rejected, since Cheung and Lai (1993) report that Johansen
tests are reasonably robust to non-normality, i.e., the tests show robustness to both skewness
Table 2.3. VEC Multivariate Diagnostic Tests
Vector Autocorrelation testa F(100,702) 0.84679 [0.8505]
Vector Normality testb χ2(10) 209.14 [0.0000]**
Vector hetero testc F(630,1623) 1.0605 [0.1846]
Note: Values in square brackets are marginal significance levels and ** indicates the null hypothesis was rejected at the 1% level. aAutocorrelation of the residuals was examined using the F-form of the Lagrange-Multiplier (LM) test, which is valid for systems with lagged dependent ariables. bHeteroshedasticity was tested using the F-form of the LM test against fourth-order autoregressive conditional heteroshedasticity. cNormality of the residuals was tested with the Doornik-Hansen test (Doornik and Hendry 1994).
and excess kurtosis, the results of the Johansen cointegration tests can be considered valid. In
addition, results of misspecification tests for the residuals of the cointegration estimation of
equation (2.4) are presented in Table 2.4. However, the heteroskedasticity found in British
Columbia price series indicates that our findings should be viewed with some caution.
In order to examine whether there is a long-run equilibrium between Canadian and US
newsprint markets, we used the Johansen procedure among all five Canadian and US price
series. The results of the rank test in Table 2.5 imply that a stationary relationship between
any two price variables is possible but that there is no single North American newsprint
market.
We further performed Johansen cointegration tests for Canadian and US newsprint markets,
respectively, in order to analyze if there was one newsprint market in Canada and/or if there
was a single newsprint market in the US. Table 2.6 and Table 2.7 report the trace test
statistics
23
Table 2.4. Misspecification tests for residuals from Johansen’s cointegration estimation of model [4] with 4 lags.
Tests for residuals and standard errors Equation
Autocorrelationa
FAR(4,163)
Heteroskedasticityb
FARCH(4,159)
Normalityc
χ2(2)
Standard error
(σe)
ΔBC
ΔON
ΔQueb
ΔWest
ΔEast
0.97 [0.42]
1.36 [0.25]
0.65 [0.63]
0.41 [0.80]
0.49 [0.75]
8.38 [0.00]**
0.23 [0.92]
0.52 [0.72]
0.37 [0.83]
0.06 [0.99]
119.57 [0.00]**
1.70 [0.43]
1.26 [0.53]
18.44 [0.00]**
14.34 [0.00]**
0.06
0.02
0.02
0.03
0.03
Note: Δ denotes the first differences of the variables, BC, ON, Quebec, West and East denote the newsprint prices of British Columbia, Ontario, Quebec, US west and US east, respectively. Values in square brackets are marginal significance levels and ** indicates the null hypothesis is rejected at the 1% level. aAutocorrelation of the residuals was examined using the F-form of the Lagrange-Multiplier (LM) test, which is valid for systems with lagged dependent ariables. bHeteroshedasticity was tested using the F-form of the LM test against fourth-order autoregressive conditional heteroshedasticity. cNormality of the residuals was tested with the Doornik-Hansen test (Doornik and Hendry 1994).
Table 2.5. Results for co-integration tests for Canadian and US markets
Critical values Null Hypothesis λ trace
10% 5%
r = 0 82.367* 66.0 70.0
r ≤ 1 44.017 45.2 48.4
r ≤ 2 18.949 28.4 31.3
r ≤3 6.656 15.6 17.8
r ≤4 0.551 6.7 8.7
*denotes rejection of the null hypothesis at 5% significant level.
for both national markets. The procedure utilized imposed no restrictions on the constant
term, and therefore, the critical values tabulated in Johansen and Juselius (1990, Table A2)
were used. The trace test was used to examine the hypothesis that there are at most r
24
cointegrating vectors, while the maximum eigenvalue test was used to test the hypothesis that
there are r+1 cointegrating vectors versus the hypothesis that there are r cointegrating
vectors. We performed both trace test and maximum eigenvalue test and the results were
consistent between the two tests. To save space, we only report the trace test results.
Table 2.6. Results of co-integration tests for newsprint in Canadian markets (BC, ON, and Quebec)
Critical values (trace test) Null Hypothesis λ trace
10% 5%
r = 0 24.538 28.4 31.3
r ≤ 1 4.616 15.6 17.8
r ≤ 2 0.736 6.7 8.1
The test results in Table 2.6 indicate that the Canadian data are not cointegrated, while the
results in Table 2.7 imply one cointegration vector in the US data. According to Johansen
rank test, the hypothesis of no cointegration (r=0) can be rejected and one cointegration
vector is accepted at the 5% level in the US (Table 2.7). In the case of Canadian price data,
all the test
Table 2.7. Results of co-integration tests for newsprint in US markets (US west & US east)
Critical values Null Hypothesis λ trace
10% 5%
r = 0 22.399* 15.6 17.8
r ≤ 1 5．706 6.7 8.1
*denotes rejection of the null hypothesis at 5% significant level.
statistics were well below the critical values and r=0 cannot be rejected (Table 2.6). The test
statistics reported in Table 2.5, Table 2.6 and Table 2.7, indicate that the stationary
relationship exists between the two US newsprint markets. Our follow-up bivariate
cointegration tests further confirmed the finding, that among the five price series, there is no
long-run equilibrium between any Canadian markets, or between any Canadian and US
25
markets. To save space, we do not report the pair wise test results but they are available from
the authors.
The five normalized eigenvectors β with weights α were obtained from the cointegration estimation of equation (2.3). The relevant cointegration vector is given by the first columns Table 2.8. Normalized eigenvectors, β1, and their weights, α1, obtained from cointegration estimation of model (2.4)
Eigenvectors weights Prices by regions β1 β2 β3 β4 β5 α1 α2 α3 α4 α5 BC 1.00 -0.18 -1.05 0.18 0.70 -0.04 0.33 0.06 0.02 -0.04 ON -1.06 1.00 -1.11 -0.87 0.39 0.02 -0.15 0.02 0.02 -0.01 Quebec -0.10 -0.61 1.00 -3.14 -
0.47 -0.03 -0.04 -0.01 0.02 -0.00
US west -8.78 -0.91 0.34 1.00 -1.02
0.05 0.04 -0.03 0.02 -0.01
US east 8.59 0.76 1.28 0.57 1.00 0.03 -0.01 -0.03 0.02 -0.02
of βs (Table 2.8). The long-term equilibrium relation, β1, normalized to British Columbia
price can be presented in vector form as
β1 = [1.00 -1.06 -0.10 -8.78 8.59] (2.7)
where 1.00 is the coefficient of British Columbia price, -1.06 is the coefficient of Ontario
price, -0.10 is the coefficient of Quebec price, -8.78 is the coefficient of US west price, and
8.60 is the coefficient of US east price. The coefficients indicate that the LOP may hold
between British Columbia and Ontario, and between US west and US east, respectively.
Table 2.9. Test results for the LOP by pairs of prices obtained from model (2.4) by restricting
β1 under r=1.
Testable prices Hypothesis (H0: pit = pjt)
Test (LR test statisticsa)
US west, US east [0 0 0 1 -1] 5.4446 aCritical χ2 value is 5.99 at 5% level.
26
However, according to our former cointegration test results, no cointegration was found in
the Canadian data, therefore LOP may hold only between US east and US west. The pairwise
test was performed by restricting two price coefficients at a time to equal 1 and -1 and the
others to equal to zero in β1 vector, i.e., restriction of [0 0 0 1 -1] was imposed. Test results
show that under one cointegration vector, the restriction [0 0 0 1 -1] was not rejected at 5%
level, which means that for the prices of US west and US east, the test supported the LOP
(see Table 2.9).
The first column of α in Table 2.8 represents the speed of adjustment to the long-run
cointegration relationship. The US west price seems to respond faster to the disequilibrium
changes than that of the US east does. The results for the weak exogeneity test in Table 2.10
reveal that for US west price, weak exogeneity was rejected, suggesting that US west price is
affected by the prices in the other four markets. Moreover, the existence of LOP between US
west and US east prices can be interpreted so that US west price is the adjusting part and the
US east price is the determining part of the relationship.
Table 2.10. Test results for weak exogeneity of newsprint prices in the North American markets.
Testable prices Test (under r = 1) αi = 0 (LR test statisticsa)
BC 0.65 ON 0.68
Queb. 0.90 US west 6.92* US east 4.65
aCritical χ2 value is 5.99 at 1% level *denotes the rejection of weak exogeneity
2.5 Discussion and conclusions
In this paper a law of one price was tested for US and Canadian newsprint price data.
Johansen’s multivariate cointegration method was applied in the empirical analysis. The
analysis was performed using monthly export unit value for Canadian newsprint, and
monthly market prices for US newsprint for the period between 1988 and 2004.
27
The finding that all the price series were non-stationary and integrated of order one is
consistent with earlier research concerning newsprint markets (e.g., Hänninen et al., 1997;
Hänninen and Toppinen, 1999; Jee and Yu, 2001). The cointegration tests further indicated
that the LOP is valid in US newsprint markets, but not in Canadian markets. Moreover, the
results showed that the law of one price does not hold for all the five markets, neither does it
hold for any pair of Canadian markets, nor for the pairs between US and Canadian markets.
These results imply that there is no single newsprint market in North America but several
regional ones. However, since the LOP does hold for the US newsprint markets, there
appears to be one US market for newsprint.
The existence of an integrated, national newsprint market in the US has important
implications. As argued before, market integration exists when price differences are no more
than the cost of transportation plus related transaction costs. As a result, changes in supply or
demand in one market affect the price and/or volume of transactions in the other. Since the
U.S. newsprint markets were integrated, the markets involved have to be modeled
simultaneously. Another implication is that changes in the prices of U.S. newsprint in one
region will lead to changes in another region, i.e., the markets are not independent. The weak
exogeneity tests seem to further indicate that the US east price might be the dominant price in
the US newsprint market.
As to Canadian newsprint market, our results indicate that there are long-run deviations from
the LOP, and therefore, price shocks in any one region are transmitted neither to the prices of
newsprint in other parts of Canada, nor to the US newsprint prices. Numerous reasons may
prevent the LOP from holding. It is possible that Canadian newsprint prices in different
regions respond differently to several macro and micro economic variables, such as exchange
rate, transport costs, and local taxes. Thus, in terms of econometric models for newsprint, the
models allowing for price differences between the main local suppliers should be used in
modeling the Canadian newsprint markets. Furthermore, the markets could be modeled as
28
separate provincial markets as local or provincial policy changes are not expected have direct
impact on overall markets in Canada or the US.
Our findings about North American newsprint markets are analogous with former studies on
softwood lumber markets in US and Canada. For example, Nanang (2000) found no evidence
that the markets for softwood lumber in Canada are integrated, while Uri and Boyd (1990),
Catimel et al., (1997), Jung and Doroodian (1994) and Yin and Beak (2005) all concluded
that a single market characterizes the US markets for softwood lumber. On the other hand,
our test results are different with the research findings made by Townsend and Uhler (1986)
and Alavalapati et al. (1997), in which little evidence of market power for Canadian pulp
exporters were found.
Given the significance of bilateral newsprint trade, the test for one newsprint market in North
America is obviously interesting and carries important implications for the US and Canadian
forest industry companies. The Johansen cointegration test, though commonly used, does not
define the degree of integration between different markets, and it does not take into account
the transaction costs in market performance. The future research should continue to explore
the issue by using, for example, persistence profiles in order to study the response of the co-
integrating relation to a system-wide shock for examining the degree of market integration.
Moreover, both consolidation and mergers and acquisitions in forest industry are creating
increasingly multinational forest products companies with opportunities to optimize their
supply chain by producing in multiple countries, and therefore, the forest product markets in
North America should be analyzed in a more global context.
29
CHAPTER III
ASSESSING MARKET LINKAGES: EVIDENCE FROM US IMPORTS
OF PULP AND PAPER PRODUCTS
3.1 Introduction
The Canadian pulp and paper industry highly relies on the demand from the US market.
Due to its geographic location, Canada has long been the only offshore supplier for pulp and
paper to the US. Today the US is still the No. 1 market for Canada, absorbing more than
60% of the Canadian pulp and paper products every year (FPAC, 2006). However, with the
innovation of communication technology, the general trend of liberalizing international
trade, and increasing activities by multinational corporations, the geographical divide
among various national markets are less obvious. The opening of markets has increased the
competition between pulp and paper products. Factors like the rapid growth in plantation
forestry in the southern hemisphere, as well as the integration of primary and secondary
production capacity from non-traditional producing regions into global supply chains, have
all contributed to an increased competition in the US market. As a result, the average
financial returns for pulp and paper industry have been lowered globally (FPAC, 2007). The
Canadian pulp and paper industry does not escape this global context, and it has been facing
a series of challenges that are virtually unprecedented in its long history. There were
closures of Canadian newsprint mills and pulp mills for the past years, and the pulp and
paper sector suffered a total reduction in its production capacity of 12 percent from 2000 to
2005 (FPAC, 2007). In order to understand why such rapid change occurs, and how to
effectively protect them, the Canadian government and industry need to acquire a global
perspective of their situation in the world market, specifically in the US market.
The fortune of Canadian pulp and paper industry still depends on the demand from the US
market (FPAC, 2006). Any changes in the US market can have important implications to
30
the Canadian pulp and paper industry. In modeling and forecasting the demand for and trade
of the Canadian pulp and paper products, it would be useful to understand the market
structure for pulp and paper in the US.
One of the most important aspects of market structure is market integration. Generally,
markets are “where prices are established” (Stigler and Sherwin, 1985), and a study of price
movements within the market is an integral component of understanding market structure.
The more nearly perfect a market is, the stronger is the tendency for the prices of identical
products moving together (Marshall, 1930; and Stiglitz, 1993) in the long-run. From the
perspective of the Canadian pulp and paper industry, a study of market integration of the US
import market for pulp and paper products is critical; because this study will provide us
information about the co-movements of prices of pulp and paper products imported from
different countries, including Canada. There are two critical components of the market
integration in the case of the US import markets for pulp and paper products: (i) the long-
run equilibrium relationship among prices of the same product imported from different
countries; and (ii) the speed of prices’ convergence to their long-run equilibrium once they
are disturbed from their equilibrium by some shocks which may be due to change in policy,
technology, or market factors. If a market needs a long period to come back to its long-run
equilibrium once shocked, then this market might be vulnerable to disruptive shocks and in
this circumstances, the Canadian government or industry should have their trade policy or
market strategy adjusted when shocks come. In addition to market integration, an
understanding of a dominant price among various prices in the US import market will
provide important information to the Canadian producers as well as policy makers.
Considering the US is both the world largest consumer and producer for pulp and paper
products, we expected the influences of US domestic prices on its import prices, and
therefore a study of the interrelationship between the US domestic prices and import prices
is also important for the Canadian producers and policy makers.
In view of the above discussions, the objective of this article are: (i) to study the market
integration in US import markets for specific pulp and paper products; (ii) to examine how
31
quickly prices adjust between pairs of locations once shocked, which is a question of degree
of integration; and (iii) to study how the US domestic market interrelates with its import
markets. The long-run market structure for US pulp and paper imports is estimated using
the maximum likelihood procedure in multivariate cointegrating vector autoregressive
(VAR) framework, and persistence profile analysis is employed to investigate the speed of
convergence to price equilibrium given a system-wide composite shock. Moreover, the
information transmission pattern between US domestic and US import markets is examined
employing generalized forecast error variance decomposition.
Different approaches have been developed to study degree of market integration. One
approach for combining the short with long run is to use an error correction mechanism.
The major difficulty of this method is in giving interpretations for the size of the adjustment
coefficients (Sims, 1980; and Lutkepohl and Reimers, 1992). Another commonly used
method to study the degree of market integration is to use impulse response functions.
However, this method is well known for the identification problems. An alternative method,
known as persistence profiles approach, suggested by Lee and Pesaran (1993) and Pesaran
and Shin (1996), has certain advantages over impulse response functions, when it is used to
analyze the speed of convergence to equilibrium within the cointegration framework.
Persistence profiles analyze the response of the co-integrating relation to a system-wide
shock for examining the degree of market integration. In this method, reaction time for
each of the long-run equilibrium relations to absorb a system-wide shock is estimated to
measure the degree of market integration.
Existing literature typically employs the Granger causality test to study the dynamic casual
relationships between economic variables. However, as emphasized in the literature (Sims,
1980; Abdullah and Rangazas, 1988), it may be misleading to relay solely on the results
determined by Granger causality tests, since Granger causality is based on statistical
significance instead of economic significance. Engle (1982) also pointed out that the
existence of conditional heteroscedasticity may cause the conventional Granger causality
tests to be not only inefficient but also inconsistent. Sims (1980) recommended that forecast
32
error variance decomposition be used to model the relationship between economic
variables. Forecast error variance decompositions illustrate the proportion of the movements
in a sequence due to its ‘own’ shocks versus shocks to the other variables in the system
(Koop et al., 1996; Pesaran and Shin, 1998). This method provides robust results that allow
one to compare and contrast the extent to which the forecast variance of one series can be
accounted by innovations to other series, and therefore to measure the relative importance
of other economic variables in influencing a particular economic variable.
The products selected for our study are, respectively, light-weight coated paper,
nonconiferous chemical wood pulp, and kraft paper and paperboard. Due to data
availability, we use monthly data to examine US import markets for light-weight coated
paper and nonconiferous chemical wood pulp, from January 1989 to December 2006,
respectively. While for Kraft paper and paperboard, quarterly data are employed from the
first quarter of 1989 to the forth quarter of 2006.
Long-run equilibriums have been found for the three selected import markets, and the
highest degree of market integration exists in the import market for nonconiferous chemical
wood pulp, while Kraft paper and paperboard has the lowest market integration among the
three import markets. We also found that the domestic US prices explain a substantial
portion of the forecast error variance of import prices for two of the pulp and paper products
of interest, that is, light-weight coated paper and nonconiferous chemical wood pulp,
respectively.
The reminder of this paper is organized as follows. We present econometric methodologies
employed in this article in next section. Subsequent sections introduce the data and the
countries selected for analysis, discuss the results of analysis of the degree of market
integration, explain the influence of US prices on import prices, and summarize the major
findings and provide conclusions.
33
3.2 Theoretical Framework
3.2.1 Approaches to Cointegration and Short-run Dynamics
We consider Johansen’s maximum likelihood procedure for cointegration analysis. The
vector error correction (VEC) model can be written as:
Δxt = μ + Γ1Δxt-1 +,…,+ Γk-1Δxt-k+1 + Πxt-k + εt (3.1)
The variable Δxt represents a p-element vector of observations on all variables in the system
at time t, μ is a (p x 1) vector of intercepts, Γi is a (p x p) matrix of short-run dynamics
coefficients, and εt is a (p x 1) vector of innovations. The ΓiΔxt-i terms account for stationary
variation related to the past history of system variables and the Π matrix contains the
cointegrating relationships. All variables must be nonstationary in levels. Moreover, Π can
be defined as Π =αβ’, where α contains short-run adjustment parameters to the long-run
relationships captured by the cointegrating relation Zt =β’Xt.
In the case of cointegrated variables, the behavior of short-run processes is believed to be
influenced by the long-run stability condition, and it is important to examine the short-run
behavior of these variables within the framework of their long-run behavior. Information
on the short-run structure involves two parts, α and the parameter Γi. α defines the error
correction adjustment through which the system is pulled back to its long-run equilibrium,
while the parameters (Γ1 ,…, Γi ) define the short-run adjustment to changes in the
variables. Since the speed of adjustment parameters yield information on how individual
variables respond to shocks which move the variables away from their implied long-run
behavior, Johansen method thus enables researchers to examine these short-run responses,
while incorporating the long-run information.
3.2.2 Degree of Integration: Persistence Profiles
The basic idea of the degree of integration is that, given a set of locations, for those that
belong to the same economic market, some will be more integrated than others. A few
34
studies have attempted to answer questions about the degree of market integration based on
the measures derived from the VEC model, by looking at the size of the adjustments (α).
The potential difficulty of this method is that interpreting the values of the speed of
adjustment can not be conducted in a formal way, since they capture only the initial
sensitivity of the cointegrated variables to a shock and, therefore, provide only partial
information of the short-run movements of the cointegrated variables (Sims, 1980; and
Lutkepohl and Reimers, 1992).
Impulse response functions have also been widely used to measure the degree of market
integration or the short-run dynamics for integrated markets. The drawback of impulse
response functions is well known. They are not unique when the shocks are correlated. In a
study of spatial prices, it is unreasonable to expect orthogonal shocks because the time
series of all prices are highly correlated. Therefore, impulse response functions are likely to
be misleading and difficult to interpret. In this paper we propose an alternative measure that
does not require imposition of an ordering on the system.
A persistence profile characterizes the response of a cointegrating relation to a system-wide,
rather than to an individual, shock (Pesaran and Shin, 1996). It measures the reaction time
of each long-run equilibrium relation to absorb a system-wide shock. Compared to the
impulse response function, the advantage of considering a system-wide shock is that the
persistence profiles are unique functions of system-wide shocks and there is no need to
orthogonalize the individual shocks, and thus is free from the non-uniqueness problem in
impulse response analysis.
In this study, the persistence profile technique developed by Pesaran and Shin (1996) is
employed to model the time profile of the response of the cointegrating relation Zt=β’Xt to
system-wide shocks. The system-wide shocks is analyzed via a draw from a multivariate
distribution of the vector εt = [ε1t , ε2 t,…, εpt]. At time t, the variance-covariance matrix of the
shock εt is Σ . We study the propagation through time t+1 to t+n of the variance of the shock,
35
conditioning on information available at time t-1. The persistence profile analysis focuses on
the incremental variance of the disequilibrium error from time t+1 to t+n. Pesaran and Shin
(1996) define the (unscaled) persistence profile as
Hz(n) = Var(Zt+n | It-1) - Var(Zt+n-1 | It-1) (n = 0,1,2,…) (3.2)
where It-1 is the information set at time t-1, Var(Zt+n | It-1) is the variance conditioned on
the information set, and n is the time horizon.
Equation (3.2) says that a persistence profile is the change in the variance of the forecast of
Zt+n , with respect to the variance of the forecast of Zt+n-1 based on the information set It-1. In
a stationary equilibrium, a shock will eventually die out. This implies that its incremental
variance becomes smaller as time passes and approaches zero as time goes to infinity.
Examination of the speed that incremental variance approaches zero thus indicates how
soon it will take the system to return to the long-run equilibrium relation once shocked. To
facilitate the comparison among different profiles, the Hz(n) need to be scaled:
hz(n) = )0()(
z
z
HnH , for n = 1, 2, … (3.3)
The profile of hz(n), where n = 1, 2, …, is of greater interest in economic analysis if β’Xt
forms a cointegrating relation, since hz(n) provides important information on the speed with
which the effect of the system-wide shocks on the cointegrating relation Zt =β’Xt,
disappears. Moreover, hz(n) has unit value at the time when n = 0, and it should tend to zero
as n → ∞.
Therefore, a further advantage of using a persistence profile is that the cointegration
framework can be directly utilized to investigate the relationship between non-stationary
variables. The persistence profile is also indicative of the stability of the long-run
relationship. Since a number of variables can adjust in a cointegrating VAR, by increasing
36
or decreasing at different rates, the cointegrated or equilibrium relations act as stabilizer for
the system. Hence, shocks to the cointegrating relationship will be eliminated and a new
equilibrium will be reached.
3.2.3 Generalized Forecast Error Variance Decomposition
The forecast error variance decomposition reveals to what extent price variation of a certain
market can be explained by innovations from other markets in the system. It can be used to
measure the relative importance of other markets in driving market returns in a particular
market. In other words, it can provide insight into the casual relationships among price
series. Compared to Granger causality tests, forecast error variance decomposition is able to
deduce the degree of exogeneity, that is, it measures the percentage of a variable’s forecast
error variance that occurs as the result of a shock from a variable in the system(Sims, 1980).
Two types of forecast error variance decomposition can be computed, the traditional
orthogonalized decomposition and the recently developed generalized decomposition. It is
well known that the traditional orthogonalized forecast error variance decomposition, based
on the widely used Choleski decomposition, might be sensitive to the ordering of the
variables. By contrast, the generalized forest error variance decomposition is invariant to the
ordering of the variables, and thus it is uniquely determined.
The above equation 3.1 can be rewritten as an infinite moving average process as that in
equation 3.4.
Δxt = iA(L) εt (i, j = 1, 2, …, p) (3.4)
where A(L) εt = ∑∞
=0ii
i LA . Variables in the VAR model include US domestic price and
import prices for relative pulp and paper products. All variables are stationary in their first
differences (unit root test results for US price are available on request). Based on equation
37
3.4, the generalized forecast error variance decomposition for the vector Δxt is given by
(Pesaran and Shin, 1998)
∑ ∑∑ ∑
=
=−
= n
l illi
n
l jliiiij
eAAe
eAen
0''
02'1
)(
)()(
σθ (i, j = 1, 2, …, p) (3.5)
Where θij (n) denotes the proportion of the n-step ahead forecast error variance of the ith
variable which is accounted for by the innovations in the jth variable in the VAR, jjσ is jjth
element of the residual variance-covariance matrix Σ of the vector Zt, Al is the coefficient
matrices in the moving average representation (Equation 3.4), and ej is a m x 1 vector with
unity at the jth row and zeros elsewhere. Based on equation 3.1, the following standards are
made: a) the disturbances are well behaved white-noise processes with positive definite m x
m covariance matrix Σ, b) the variables in the VAR are stationary, and c) the regressors are
not perfectly collinear.
Forecast error variance decomposition tells us the proportion of the movements in a
sequence due to its ‘own’ shocks versus shocks to the other variables in the system (Enders,
1995; Sims, 1982). If shocks to one equation in the VAR do not explain any of the forecast
horizon of the variable of interest at any forecast horizon, then the latter is said to be
exogenous. On the other hand, if the shocks explain all of the forecast error variance in the
variable of interest at all forecast horizons, then it is said to be entirely endogenous.
3.3 Data
In selecting specific commodities and countries, we apply the following two criteria. One is
that the data has to be at the most disaggregate level, both in terms of commodity and time,
so that prices would be defined as accurately as possible. The other is that imports of a
commodity from different countries are of sufficient volumes to allow for inter-country
comparisons. The three commodities selected are: 1) chemical wood pulp, soda or sulfate,
nonconiferous (Harmonized System Code, or HS Code, 470329), called “BHKP” in the rest
38
of this paper, 2) light-weight coated paper (HS Code 481021), called “LWC” in the rest of
this paper, and 3) kraft paper and paperboard (HS Code 481029), called “Kraftpaper” in the
rest of this paper. However, we did not consider the newsprint, one of the most traded pulp
and paper products, in our analysis for two reasons. First, Tang and Laaksonen-Craig (2007)
already studied newsprint markets in the US and Canada specifically. Second, Canada
seems to be the single supplier of newsprint to the US market for many years, and import
data for countries other than Canada are not continuous, even at a quarterly level.
Fig. 3.1. US imports of LWC by quantities, 1989-2006 Data source: USITC
0
100000
200000
300000
400000
500000
600000
700000
800000
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
year
tons
Canada Finland Germany
For most of pulp and paper products, Canada is by far the most important trading partner for
the US (Bolkesjo and Buongiorno, 2006). Nevertheless, imports from European countries to
the US have been increasing gradually for the past years. For example, US imports of LWC
from Finland and Germany have grown rapidly and steadily since year 2000 (fig.3.1).
Moreover, for pulp products, like non-coniferous wood pulp (BHKP), Brazil seems
dominant in the market (fig. 3.2).
39
The countries selected are Canada and Brazil for BHKP, Canada, Finland and Germany for
LWC, and Canada and Germany for Kraftpaper. In year 2006, these countries exported to
the United States 2.2 billion US dollars worth of the three commodities of interest. These
represented 97% of all the BHKP imported by the United States, 89% and 36% of all
imports of LWC and Kraftpaper, respectively. Canada is by far the largest exporter among
the countries considered, particularly for LWC and Kraftpaper. The large differences in
quantities imported from different countries should be useful in revealing market power, if
any.
Fig. 3.2. US imports of BHKP by quantities, 1989-2006 Data source: USITC
0
500000
1000000
1500000
2000000
2500000
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006year
tons
Br azi l Canada Wor l d
The price of imports is measured by the unit value of commodities, based on CIF figures, in
US dollars. Data on US import quantities and values were obtained from the database US
Foreign Trade Statistics, and the data are available at http://dataweb.usitc.gov. Data for
BHKP and LWC are monthly, and cover the period from January 1989 to December 2006,
while data for Kraftpaper are quarterly from 1989 to 2006. In some cases, imports from
countries other than Canada did not occur for certain months, therefore, price data are not
40
available for that period. This occurred for imports of Kraftpaper. Instead of generating
monthly price data, we use quarterly data for Kraftpaper. As to the US data, they are
domestic price data provided by RISI (www.risi.com). All unit price series were deflated by
the producer price index (1982 = 100), which was obtained from the US Bureau of Labor
Statistics.
Fig. 3.3. LWC imports (real unit value in logs) from Canada, Finland, and Germany to the USA, and domestic US price (real price in logs), 1989:01 – 2006:12
5.8
6
6.2
6.4
6.6
6.8
7
7.2
7.4
Jan1989
Jan1990
Jan1991
Jan1992
Jan1993
Jan1994
Jan1995
Jan1996
Jan1997
Jan1998
Jan1999
Jan2000
Jan2001
Jan2002
Jan2003
Jan2004
Jan2005
Jan2006
year
real
uni
t val
ue in
logs
USA Canada Finland Germany
Fig. 3.3-3.5 show US domestic and import prices for above mentioned products,
respectively. For LWC, after stable price development during early 1990s, there is a sharp
fall in all prices in the middle 1990s, and this fall continues till year 2003. The three import
prices as well as US price of LWC seem to follow the same trend. The prices for BHKP
also follow the same trend, and they are relatively stable compared to the price of LWC.
Things are complicated for Kraftpaper, though Canada and US price is rather stable with a
downward trend, German price is rather volatile. Unlike LWC and BHKP, price difference
between any two series of Kraftpaper is obvious.
41
Fig. 3.4. Imports of BHKP (real unit value in logs) from Canada and Brazil to the US, and domestic US price (real price in logs), 1989:12 – 2006:12
5
5.5
6
6.5
7
7.5
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
year
real
uni
t val
ue in
logs
USA Canada Brazil Fig. 3.5. Kraftpaper imports (real unit value in log) from Canada and Germany to the US, and domestic US price (real price in logs), 1989 (first quarter) – 2006 (forth quarter)
6
6.2
6.4
6.6
6.8
7
7.2
7.4
7.6
7.8
8
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
year
real
uni
t val
ue in
logs
USA Canada Germany
42
3.4 Empirical Results and Discussion
In addition to studying the long-run market structure, it would be more revealing to examine
how prices adjust interactively among themselves, under the constraint of the identified
long-run equilibrium price relations. To complete the analysis of short-run dynamics, the
following stages are carried out. First, unit root tests were used to assess the time series
properties of the variables of interest. Once it was found that these variables do have unit
roots, the next stage was to carry out the cointegration test. The final stage was estimation
of the persistence profiles measure, as well as the tests of generalized forecast error
variance.
Fig. 3.6 Price series for LWC, by level and first difference, respectively
1990 1995 2000 2005
6.50
6.75
7.00
7.25Canada
1990 1995 2000 2005
-0.2
0.0
0.2 DCA
1990 1995 2000 2005
6.50
6.75
7.00Finland
1990 1995 2000 2005
-0.2
0.0
0.2Dfinland
1990 1995 2000 2005
6.50
6.75
7.00
7.25Germany
1990 1995 2000 2005
-0.25
0.00
0.25 Dgermany
3.4.1 Order of Integration: Unit Root Tests and Tests of Multivariate Cointegration
Before testing whether the price series are cointegrated, one should check that each
univariate series is nonstationary, or I(1). Graphs of prices on levels and on differences for
43
three products of interest are presented in Fig. 3.6 ~ Fig. 3.8. Visual inspections of the
graphs of the price series suggest all series are nonstationary, while their first differences
are stationary.
Fig.3.7. Prices series for BHKP, by level and first difference
1990 1995 2000 2005
5.75
6.00
6.25
6.50
6.75 Canada
1990 1995 2000 2005
-0.2
-0.1
0.0
0.1
DCA
1990 1995 2000 20055.5
6.0
6.5
7.0 Brazil
1990 1995 2000 2005
-0.5
0.0
0.5DBrazil
Many unit root tests have been suggested to examine stationary properties of a time series,
none of them is universally superior to the others. Each test has high power only under
certain conditions. For example, in implementing Augmented Dickey Fuller(ADF) method
it is important to choose the appropriate specification of the deterministic terms, i.e.,
whether a constant or time trend should be included in the model. Another critical problem
to be address in applying ADF is to select proper lag length. Hamilton (1994, p.528-529)
described the four different cases in which the ADF test can be used. According to the
proposal of Perron (1988), the model was selected from the most general trend specification
and test down to more restrictive specifications. In addition, we selected the lag length using
44
Hall (1994) general-to-specific criterion. The results of ADF tests are presented in Table
3.1. ADF tests were performed on the natural logarithmic values of each of the variables on
the full sample for the period 1989 – 2006, both on levels as well as on the differenced
forms. The ADF test results further confirm our visual inspections that there is a unit root in
each of the price series, but no unit root in their first differences at the 5% significant level.
Fig. 3.8. Price series for Kraftpaper, by level and first difference, respectively
1990 1995 2000 2005
6.6
6.8
7.0canada
1990 1995 2000 2005
-0.1
0.0
0.1
DCA
1990 1995 2000 2005
7.0
7.5
Germany
1990 1995 2000 2005
-0.5
0.0
0.5Dgermany
As for cointegration test, there are five different specifications of for the VEC model
(Johansen, 1995, p.80-84). We chose the one that with no deterministic trends but with
intercepts, since the first-differenced price series are all stationary without drift and linear
trend. The Akaike information criterion (AIC) is used to determine the lag length in the
model. To check whether there is any departure from the standard assumptions on the
model, we conducted diagnostic tests for the residuals of our data with different lag lengths,
before we use the Johansen procedure to determine the number of cointegrating
45
relationships in the data by estimating the equation (3.1). These tests include serial
correlation, heteroskedasticity, and normality. We further report the test results below.
Table 3.1. Augmented Dickey-Fuller (ADF) unit root test results
ADF test results Price by supplier countries
for products of interest Levels First differences
LWC ADF # of lags ADF # of lags
Canada -1.60 1 -3.51* 10
Finland -1.32 7 -4.37* 7
Germany -1.06 11 -3.71* 10
BHKP
Canada -1.60 5 -4.55* 8
Brazil -1.32 7 -4.91* 9
Kraftpaper
Canada -2.03 4 -5.26* 8
Germany -2.12 14 -4.97* 11
Note: *denotes the rejection of the null hypothesis of nonstationarity. The critical t-value is -3.49 at the 5% level.
LWC -- In the case of LWC we model a system in which there are three endogenous
variables: logarithm of real unit import value from Canada, Finland, and Germany,
respectively. We use a VAR model with five lags6. Diagnostic tests for the residuals of each
equation and the corresponding vector test statistics supported the model with five lags as a
sufficient description of the data (Table 3.2).
As explained in section II, if the vector VAR(k) contains some I(1) series, it is important to
detect whether there exists a coefficient vector β which leads Zt =β’Xt to become stationary.
The cointegration test developed by Johansen tests the rank of the vector X. If r > 0, this
6 The VEC model is very sensitive to the number of lags. An inappropriate lag can distort the size of the test and results in loss of power. Too few lags may result in over-rejecting the null when it is true, whereas too many lags may reduce the power of the test.
46
result shows that this system is cointegrated. The analyses of the appropriate rank of the
cointegration vectors for the three pulp and paper products are presented in Table 3.2.
The cointegration test results indicated 2 cointegration vectors among the three LWC import
markets. According to the Johansen rank test, the hypothesis of no cointegration (r = 0) and
one cointegration (r = 1) could be rejected at the 5% significant level respectively, and two
cointegration vector was accepted at the 5% level (Table 3.3). The results in rank test in
Table 3.3 thus imply that the simultaneous long-run equilibrium exists among the three
markets, e.g., Canada, Finland, and Germany.
BHKP -- Two exporting countries, i.e., Canada and Brazil, were chosen to study the US
import markets for BHKP. Canada and Brazil are the two major exporters of BHKP to the
US market, accounting for 89% of woodpulp imported by the US in 2006. The diagnostic
tests show that the model with two lags describes the data well. Though the null hypothesis
of normality was rejected for both markets, it does not bias the results for Johansen’s
cointegration tests (Gonzalo, 1994).
Table 3.3 shows the test results of BHKP imports from Canada and Brazil markets,
respectively. The hypothesis of no cointegration (r = 0) could be rejected and one
cointegration vector was accepted at the 5% level, which indicates that the stationary
relationship exists between these two markets.
Kraftpaper -- Same as BHKP, only two countries, i.e., Canada and Germany, were
selected to study US imports for Kraftpaper. As mentioned in the previous section, for some
periods there is no import of Kraftpaper to the US from countries other than Canada,
monthly data therefore are not available for those periods, quarterly data were used instead
for relevant tests. Lags of five were selected for the VAR model and the diagnostic tests
indicate a well specified model (Table 3.2).
47
The likelihood ratio tests for the null hypothesis of no cointegration vectors is rejected
against the alternative hypothesis of the existence of one cointegrating vector at the 5%
level of significance (Table 3.3). Hence, the cointegration tests reveal that there is one
stationary linear combination between Canada and Germany, in terms of import prices. Table 3.2. Misspecification tests for residuals from Johansen’s cointegration estimation of model (3.1)
Tests for residuals and standard errors
Equation Autocorrelationa Heteroskedasticityb Normalityc Standard error
LWC: lag=5 FAR(5,190) FARCH(5,185) χ2(2) (σe)
Canada 0.69[0.63] 1.38[0.23] 66.39[0.00]* 0.05
Finland 2.15[0.06] 1.95[0.09] 25.19[0.00]* 0.04
Germany 1.68[0.14] 1.75[0.13] 26.72[0.00]* 0.06
BHKP: lag=2 FAR(2,204) FARCH(2,202) χ2(2) (σe)
Canada 2.49[0.09] 1.87[1.57] 11.24[0.00]* 0.06
Brazil 0.84[0.43] 1.96[0.14] 274.37[0.00]* 0.13
Kraftpaper:
lag=5
FAR(5,190) FARCH(5,185) χ2(2) (σe)
Canada 0.34[0.71] 1.42[0.25] 3.87[0.14] 0.06
Germany 2.20[0.12] 0.18[0.83] 19.29[0.00]* 0.18
Note: Probablities for acceptance of the null hypotheses of no autocorrelation, homoskedasticity of variance, and normal distribution are given. aAutocorrelation of the residuals was examined using the F form of the Lagrange-multiplier (LM) test, which is valid for systems with lagged dependent variables. bHeteroskedasticity was tested using the F form of the LM test against fourth-order autoregressive conditional heteroskedasticity. cNormality of the residuals was tested with the Doornik–Hansen test (Doornik and Hendry 1994).
*The hypothesis was rejected.
3.4.2 Speed of adjustment towards the equilibrium: Persistence Profiles
The persistence profile can provide complementary evidence that the estimated vectors are
indeed cointegrating relationships. The persistence profiles point estimates for the
cointegrated relation are reported in Fig. 9 – Fig.11. The effect of a shock would persist
forever if relations between I(1) variables are not cointegrated; a shock will eventually
48
disappear as the economy returns to its long-run equilibrium. The process of adjustment for
the three products shows that for the import markets of all the three commodities, the
impact of a system-wide shock is transitory and eventually disappears as the economy
returns to its long-run equilibrium.
Table 3.3 The results of cointegration rank tests
Null hypothesis H0: r≤ i
λ trace statistics (T(i))
95% critical value
LWC r=0 63.82 31.54 r≤ 1 27.11 17.86 r≤ 2 0.75* 8.07
BHKP r=0 49.60 17.86 r≤ 1 6.12* 8.07
woodfree r=0 18.76 17.86 r≤ 1 4.97* 8.07 *The null hypothesis was rejected at the 5% level.
The persistence profiles provide answers to the questions like, what happens if a random
shock hits this long-run equilibrium relationship, and how fast does the system return to the
equilibrium state? The curves in the figures are the adjustment that the effects of system-
wide shocks decline approximately monotonically for all the three import markets, and
equilibrium appears to be regained quickly and consistently throughout these markets. As
shown in Fig. 3.9, the major impact of any “typical” system-wide shock to the cointegration
relation dissipates within a period of around 8 months for LWC, while the CV1 and CV2
denote the two integrating vectors among the three import markets. Fig.3.10 presents the
persistence profiles for BHKP. It takes only 4 months for the system-wide shock to be
eliminated. For Kraftpaper, it takes longer time, e.g., 18 months or 6 quarters, to let the
system-wide shock disappear (Fig. 3.11). It can also be observed that for LWC, the
adjustment is 70% and 90% for CV1 and CV2, respectively, after the first month. After the
eighth month the marginal change in adjustments is not very significant. As to BHKP, the
adjustment is even faster, i.e., 90% after the first month, and deviations from the long-run
49
equilibrium are eliminated in about 4 months. The adjustment speed of Kraftpaper price
series is relatively slow, though 90% of the adjustment is completed after the first quarter,
the shock does not disappear after 6 quarters, or 18 months.
Fig. 3.9. LWC: Persistence profile of the effect of a system-wide shock
Fig. 3.10. BHKP: Persistence profile of the effect of a system-wide shock
Fig. 11. Kraftpaper: Persistence profile of the effect of a system-wide shock
50
Therefore, the persistence profile test results further indicate that the import markets for the
three products of interest are cointegrated, respectively. The persistence profiles show that
almost full adjustments for LWC and BHKP are completed within a year, while adjustment
for Kraftpaper takes a longer period. The fact that shocks have short-life effects on the
cointegrating relation, is an indication that the markets are closely related and that economic
forces act rapidly; hence, short-run discrepancies in the equilibrium relationships do not
grow systematically over time. In addition, the results with respect to market efficiency are
mixed. When adjustment takes longer, the possibility of short-run profits exists. This,
however, could reflect the existence of substantial trading cost.
3.4.3 Causality tests: Generalized Forecast Error Variance Decompositions
The forecast error variance of each variable from the VAR system is decomposed into
components, which account for innovations in all the variables. The more exogenous a
variable is, the less its forecast error variance is explained by innovations in the other
variables. Tables 3.4-3.6 present results of the generalized forecast error variance
decompositions.
Table 3.4. Generalized forecast error variance decomposition for LWC: Period 10
By Innovations in: Market
Explained USA Finland Germany Canada
USA 0.917 (83%) 0.019 (2%) 0.117 (10%) 0.055 (5%)
Finland 0.554 (51%) 0.384 (35%) 0.099 (9%) 0.047 (4%)
Germany 0.544 (48%) 0.033 (3%) 0.478 (42%) 0.076 (7%)
Canada 0.690 (56%) 0.113 (9%) 0.120 (10%) 0.316 (25%)
Notes:1 All the variables are in their first differences. 2Entries in each cell are the forecast error variance (percentage in parentheses) of the market in the first column explained by the market in the first row.
To conserve space, the tables only provide the results for horizons of 10 periods (measured
in months for BHKP and LWC, in quarters for Kraftpaper, respectively), which are
representative of the results at other periods (available upon request from the authors).
51
Looking through the main diagonal of Table 3.4-3.6, we may ascertain the extent to which a
variable is exogenous since this represents how much of a market variance is being
explained by movements in its own shocks over the forecast horizon. In a statistical sense, if
a variable explains most of its own shock, it does not allow variances of other variables to
contribute to it being explained and is therefore said to be relatively exogenous. We note
that for all three products, the fluctuations of US prices are explained mostly by its own
market, which are, respectively, 83% for LWC, 72% for BHKP, and 86% for Kraftpaper.
The US market for the mentioned three products thus could be regarded as unresponsive.
Such unresponsiveness alone could be evidence for an isolated market or a leadership
market, which can be further clarified by its influence on other markets.
Table 3.5. Generalized forecast error variance decomposition for BHKP: Period 10
By Innovations in: Market
Explained USA Canada Brazil
USA 0.862 (72%) 0.338 (28%) 0.001 (0%)
Canada 0.522 (42%) 0.722 (56%) 0.014 (1%)
Brazil 0.467 (39%) 0.426 (36%) 0.305 (25%)
Notes:1 All the variables are in their first differences 2Entries in each cell are the forest error variance (percentage in parentheses) of the market in the first column
Table 3.6. Generalized forecast error variance decomposition for Kraftpaper: Period 10
By Innovations in: Market
Explained USA Germany Canada
USA 0.890 (86%) 0.139 (13%) 0.002 (1%)
Germany 0.063 (6%) 0.078 (7%) 0.903 (87%)
Canada 0.169 (18%) 0.758 (79%) 0.035 (3%)
Notes:1 All the variables are in their first differences 2Entries in each cell are the forest error variance (percentage in parentheses) of the market in the first column explained by the market in the first row.
We next examine the bi-directional causality between US domestic and US import markets.
Firstly, we want to know whether the US market could be affected by its import markets.
52
We note that import markets of LWC and BHKP seem to have limited influence on
domestic US market. For LWC, the three import markets, i.e., Canada, Finland and
Germany, have little influence on US domestic market in general, while Germany has a
relatively important impact on USA. At ten- period horizon, Germany can explain 10% of
the variability of USA. For Kraftpaper product, Germany shocks explain 13% of the
variance in the US, while Canada shocks almost has no influence on the US. As to BHKP,
shocks to changes in Canada are relatively important in accounting for fluctuations in the
US, i.e., 28%.
In general, the US market is not dominated by its import market. We then want to know
whether the US market is a leadership market, by examining the influence of US market on
its import markets. The results show that the US dominates the other variables in terms of
explaining the variability, for LWC and BHKP, respectively, according to Tables 3.4-3.5. It
therefore implies that the US domestic prices are important in accounting for fluctuations in
relevant import prices. We can note that for LWC, the US shocks explain 51% of the
variance in Finland, 46% in Germany and 58% in Canada, respectively. For BHKP, USA
still easily dominates the field explaining the variability of Canada (42%) and Brazil (39%).
However, domestic US prices have limited influence on Kraftpaper import markets, since
the shocks to US price can only explain 6% and 18% of the variance in Germany and
Canada, respectively, according to Table 6.
The overall impression of Tables 3.4-3.6 suggests that, with the exception of Kraftpaper,
shocks to USA are important in accounting for fluctuations in the other variables.
Moreover, the US markets for LWC and BHKP seem to take the leadership in terms of
price changes, while it is somewhat isolated for Kraftpaper.
3.5 Conclusions
Price transmits information about changing demand and supply conditions to buyers and
sellers, and widening price-cost margins that signal profit opportunities to which alert
53
entrepreneurs respond. In addition, economists argue that well-integrated markets can
facilitate adjustment in net export flows across spaces, thereby reducing price variability
faced by customers and producers. This study examines the long-run market linkage, how a
system wide shock may affect the long-run relationship and short-run dynamic linkages
among the US import markets for pulp and paper products, and the dynamic
interrelationship between US domestic and US import markets for pulp and paper products.
Johansen’s (1995) multivariate cointegration method was applied to test market integration,
while the methodology developed by Pesaran and Shin (1996) was applied to the further
analysis in order to estimate the degree of market integration. Moreover, generalized
forecast error decomposition was discussed and implemented, to test the causality between
US domestic and US import markets, and to examine how much the shocks to domestic US
prices explain movements in its import markets. The test results were calculated using
monthly import unit values, deflated by producer price index, for imports of LWC and
BHKP to the US, for the period January 1989 – December 2006. In addition, quarterly
import unit values deflated by the producer price index were used for tests on US import
market for Kraftpaper, for the period from the first quarter 1989 – fourth quarter 2006.
The findings of this paper can be summarized as follows. First, the unique long-run
equilibrium existed in the US import markets for LWC, BHKP and Kraftpaper,
respectively. The results supported two cointegration vectors in the LWC data, one
cointegration vector in BHKP and one cointegration vector in Kraftpaper. Second, given a
system-wide shock, all three markets can come back to their long-run equilibrium in a
relatively short period. Our test results also show that the system-wide shock could be
absorbed effectively and efficiently by the market, especially for BHKP, LWC, and new
equilibrium could be reached quickly after the shock. Moreover, we find that shocks to
domestic US prices for relevant pulp and paper products explain a substantial amount of
movements in import prices, for LWC and Kraftpaper.
In conclusion, the US import market for pulp and paper products seems to have strong
market integration among its exporters. This finding is in line with previous studies on pulp
54
and paper market. For example, Buongiorno and Uusivuori (1992) indicated that most
markets for US pulp and paper exports are cointegrated. Kainulainen and Toppien (2006)
also found uniform price behaviour between the main markets in Europe for LWC and
Kraftpaper. Since market integration exists, changes in supply or demand in one market
affect the price in the others. In addition, as the most traded product in international market,
pulp and paper from different countries are expected to have their price tied closely, since
one important aspect of market globalization is that market prices are aligned so closely that
movements in import prices of a specific pulp and paper product from one country
immediately affect the prices of the same products from other countries, through efficient
information sharing. The methodology in this paper can be used to draw inferences about
the existence of market efficiency, even though it is not a direct test of market efficiency
(Saltoglu, 1998). A higher degree of market integration promotes faster adjustments of
commodities prices to information flows, leading to more efficient markets.
The results of this study also add to the literature on the interrelationship between US
domestic and import markets for pulp and paper products. A robust forecast variance
decomposition suggests that the US market is critical, especially for LWC and BHKP
products, since shocks to US prices can account for much of the fluctuation in import
prices. Our findings are especially interesting given the importance of US market for pulp
and paper products, for two reasons. First, the relative roles that shocks to the US domestic
prices play in terms of being transmitted to import prices have been identified and
documented. Second, in addition to testing market integration and the degree of market
integration, the paper has illustrated the usefulness of the generalized forecast error variance
decomposition as an informative tool for examining how price series are related.
55
CHAPTER IV
MEASURING THE COMPETITIVENESS OF CANADIAN PULP AND
PAPER IN THE US MARKET
4.1 Introduction
The Canadian pulp and paper products industry is a cornerstone of the Canadian economy,
and one of the major contributors to the Canadian exports. Any deterioration in the
performance of this industry will adversely affect the Canadian balance of payment as well as
the well-being of Canada. In recent years, there has been a common concern in forest sector
about the performance of this industry. For example, from 2000 to 2005, the pulp and paper
sector suffered a total reduction in its production capacity of 12 percent (FPAC, 2007).
During 2006, several Canadian pulp and newsprint mills were closed, and paper production
fell by 8% compared to 2005 (Pricewaterhouse, 2007). These outcomes are attributed to the
emergence of Brazil, Russia, Scandinavian countries, and the United States as pulp and paper
exporters. As an export-focused industry, it is crucial for Canada to maintain the
competitiveness for its pulp and paper products in the world market. The US market, being
the largest market for the Canadian pulp and paper products, is of specific importance to
Canada. Therefore in this paper we try to identify whether the problems encountered by the
Canadian Pulp and paper industry are due to its decreased competitive position in the US
market or not.
Generally, improved productivity is seen as a way of enhancing competitiveness of an
industry because improved productivity helps a company lower its production costs, sell
more products at a lower price, and enhance its relative position to compete. Hence, many
resource economists have used productivity analysis, which includes the study of factor
substitution and total factor productivity, as a tool to understand the competitive position of
the Canadian pulp and paper industry. For example, Muller 1979; Sherif 1983; Martinello
56
1985; Nautiyal and Singh 1986; Hailu and Veeman 2000; Hailu and Veeman 2001 have
studied the productivity of the Canadian pulp and paper industry for different time periods
and for different product groups. Hsue and Buongiorno (1994) have compared the
productivity of the pulp and paper industries in the United States and Canada for the period of
1961-1984, and Oum et al. (1991) have compared the productivity of pulp and paper industry
for Canada, the United States and Sweden for the period of 1970-82.
The study of productivity or supply (factor) side is essential to understand the competitive
position of any industry, but it is not sufficient to provide the complete picture of
competitiveness. As per the Porter’s Diamond (1990), which has been used by many scholars
to study competitiveness of various industries such as air freight services and the electronics
industry in southeast Asia (Bowen and Leinbach, 2006), global automotive industry
(Sledge,.2005) and higher education in the U.K. (Curran, 2001), there are four critical
dimensions of competitiveness – factor conditions, demand conditions, firm’s strategy, and
related and supporting industries. In addition, various macro-economic factors such as
exchange rate and trade policies also play a critical role in the competitiveness of any
industry. Hence, it is necessary to extend the research on the competitiveness of the Canadian
pulp and paper industry beyond productivity. In this paper, we will study the competiveness
of the Canadian pulp and paper industry in the US market from the perspective of demand
side.
One approach to study the competitiveness of an industry in an export (the USA) market,
from the demand perspective, is to analyze the elasticity of substitution of its product (say
pulp from Canada) with respect to the same product from other country (say pulp from Brazil
or even pulp from the USA) which are used as factors in the same production process (say
newsprint in the USA). Generally, the higher the elasticity of substitution between the
product from two country’s—the buyers shift more completely from one country’s product to
the other country’s product in response to small relative price changes—the more likely it is
that changes in competitiveness will be observable only in quantity shifts and not in price
movements (Kravis, Lipsey, and Bourque, 1965, p. 20). For example, when prices for certain
57
standard raw materials move together in all countries, in these cases a loss of competitiveness
by a given country appears as a decline in the margin of price over costs (Kravis, et. al., 1965,
p.20). Keeping this in perspective, many scholars, such as Caballero (1991), Boone (2000),
Aghion et al. (2001), and Chang and Nguyen (2002) have used the concept of product
substitution to measure the competitiveness of an industry. In forestry sector, only few
studies have addressed the substitutability among imported and domestic wood products. For
example, Nagubadi et al. (2004) have examined the issue of substitutability between various
softwood lumber products in the US market, and Uusivuori and Kuuluvainen (2001) have
studied the substitution between the main categories of imported wood and between imported
and domestic wood raw material in 36 most important wood-importing countries. However,
there is no study on the Canadian pulp and paper sector.
The elasticity of substitution measures how a ratio of factor inputs responds to a change of
the ratio of factor input prices. This way the elasticity of substitution of imported products
provides information on how these factors compete in the export market. Therefore, the
findings of this paper would provide complementary information, to the supply side studies,
from the demand side on the competitiveness of Canadian pulp and paper products in the US
market. However, this study will contribute only incrementally to our understanding of the
competitiveness of the Canadian pulp and paper industry because we will not address many
other critical issues such as firm’s strategy, related and supporting industries, and macro-
economic factors such as exchange rate in this study.
We use the sub-cost function and translog form of the function to study the elasticity of
substitution of three categories of pulp and paper products. These categories include one type
of pulp - chemical wood pulp, soda or sulfate, nonconiferous (BHKP hereafter), and two
types of paper - newsprint, and Light-weight coated paper (LWC hereafter). All three
categories are treated as intermediate goods instead of end products, considering BHKP is the
factor input for paper production; newsprint for printing daily newspapers; and LWC for
magazines, catalogs, advertising brochures and inserts, and other types of commercial
printing. We use Allen-Uzawa elasticity of substitution (AES) as well as Morishima elasticity
58
of substitution (MES) (for the reasons explained in the next section), and own- and cross-
price elasticity of demand to examine the substitution. In addition, we use Ryan and Wales
(2000) method to impose local concavity on the translog sub-cost function so that our
substitution results are theoretically sound.
Our analyses are based on monthly dataset for the period of 1:1999 to 7:2007. The
competition between Canada, Brazil and the rest of other countries are studied for BHKP
while the substitution between US, Canada and the rest of other countries are examined for
newsprint and LWC, respectively, this choice of countries is dictated by the availability of
data. We find that there is no major change of the competitive position for Canadian pulp and
paper products during the research period.
Next, theoretical background of sub-cost function and elasticity of substitution are described.
The third section outlines the data used in the estimation, while estimation results are
reported and discussed in fourth section. Concluding remarks are made in the final section.
4.2 Theoretical Model
We choose to represent the demand for pulp and paper in the US market using the two-stage
approach suggested by Fuss (1977) and applied by, Uusivuori & Kuuluvainen (2001), and
Nagubadi et al. (2004). We consider the US as a producing agent which processes the
intermediate products further and responds to the import prices as if they were production
factor input prices. The two-stage approach employed in our study is in fact a separable cost
function. The advantage of assuming separability is that it allows us to reduce the data
demands of the analysis. Weak separability of the production function implies that the ratio
of two inputs in the same group is independent of changes in the prices of inputs outside the
group. Consequently, the derived-demand elasticities must be equal for inputs within a group
with respect to changes in prices of inputs in other groups.
4.2.1 Demand for aggregate inputs
59
The translog function is based on a second-order approximation to an arbitrary production
function that places no restrictions on the elasticities of substitution (Christensen et al., 1971).
On the assumption that the firm adapts instantly to price changes, the method allows for good
predictions of the effects caused by changing pulp & paper prices from a specific country on
the overall demand for pulp & paper in the US market. The translog cost function can be
stated as follows:
Ln C=
∑ ∑∑∑= ===
++++++n
j
n
iYYiiYYjiij
n
i
n
iii YYpYppp
1 1
2
110 )(ln
21)ln()ln(ln)ln()ln(
21)ln( μαααααα
4.1)
where C is total cost of production and Pi, i = S, L, K, E are input prices. Specifically, S is
pulp or paper input, L, K, E denote aggregate inputs of labor, capital and energy. In addition,
Y denotes the gross output of the pulp-utilizing or paper-utilizing industries. For pulp-
utilizing factories, the output is various kinds of paper; while for paper-utilizing factories, the
final products could be, in our case, newspaper and commercial prints like magazines,
catalogs and etc.
According to Shephard’s lemma, the demand of ith input is given by
∑ ++==∂∂ Yp
CXP
PC
iYjijiii
i
lnlnlnln ααα 4.2)
where i, j = S, L, E, K.
The neoclassical production theory imposes the following restrictions on the above
parameters:
∑ =i
i 1α 4.3a)
∑ ∑ ==i j
jiij 0αα i, j = S, L, E, K 4.3b)
60
jiij αα = , i ≠ j 4.3c)
∑ =i
iQ 0α 4.3d)
Those restrictions ensure that the cost function has such properties like symmetry and
homogeneous of degree one. In addition, symmetry and linear homogeneity conditions
further ensure that the sum of factor shares in total cost adds up to unity, which is known as
adding up condition.
4.2.2 The demand for pulp/paper input components
It is frequently the case that the analyst has only observation on a subset of the firms’ inputs.
The data sets in this paper, for example, contain detailed information regarding pulp/paper
use but not on any other input. In this case, it is necessary to assume that the productivity
technology is seperable in its inputs. In particular, suppose PS is a function of pulp/paper
prices originating from different countries such that PS = (PS1, …PS
N), the second stage
minimization is characterized by so-called sub-cost function which can be written as
CS = f (PS1, …PS
N, QS) 4.4)
Where CS is the total cost of pulp/paper component, and QS is aggregate pulp or paper
consumption by pulp-utilizing or paper-utilizing industries, respectively, in the US. The
primary gain from the two-stage approach, under the assumption of weak separability, is that
the cost equations of the pulp/paper input can be estimated independently of other inputs. In
other words, the total cost function 4.1) is composed of M sub-cost functions, each of which
depends only on its own price or a subset of the N input prices. This saves degrees of
freedom. Furthermore, the weak separability of the production function implies that a change
in the total amount of any aggregate factor of production (S, L, E, K) does not affect the
marginal rate of substitution between the components of any other aggregate factor. For
example, a change in L affects the optimal amount of S but does not affect the relationship
Si/Sj within the S, while i, j here denote different sources of pulp or paper.
61
In order to emphasize substitution effects of pulp or paper from different countries, the total
pulp or paper consumption will be held constant (Fuss, 1977). Therefore, the demand for pulp
or paper from different countries, in terms of shares in the cost of the pulp or paper aggregate,
takes the form
∑+=∂∂
=j
jijii
s
i PPCm lnββ 4.5)
Where mi is the cost share of pulp or paper imports from ith country to total pulp/paper
consumptions in the US. To be consistent with production theory, the cost share function
must be homogenous of degree one in pulp/paper prices, that is,∑ = 1im , which requires
following restrictions:
βij = βji; ∑ βi = 1; ∑ βij = ∑βji = 0 4.6)
Therefore a system of demand functions expressed as cost shares for pulp or paper from
different countries was constructed, for the purpose to investigate the elasticity of substitution
in demand for pulp/paper in the US market.
When Equation 4.5) is estimated subject to constraints imposed by neoclassical production
theory, the structure of substitution and price elasticities of demand for pulp/paper in the US
can be obtained given any set of relative prices and total pulp or total paper consumption.
4.2.3 Elasticity of Substitution & Price Elasticity of Demand
The elasticity of substitution is due to Hicks. Hicks’ technology was designed to measure
two-factor substitution only, and therefore a number of generalizations to more factors have
been developed, including Allen, Morishima and McFadden’s measures. The most important
information provided by the elasticity of substitution is the relative input responsiveness to a
change in relative input prices. The elasticity is higher the “easier" is the substitution of one
input for the other.
62
When there are more than two inputs used in production, there is no unique measure of
substitutability. A conventional measure is the Allen partial elasticity of substitution (AES),
introduced by Allen (1938). From Uzawa (1962), the AES between inputs i and j for a twice-
differentiable cost function (C) is defined as
ji
jiijij SS
SS+=
βσ 4.7a)
2
2
i
iiiiii S
SS −+=
βσ 4.7b)
i, j = 1, … , n, i ≠ j
The Allen partial elasticity of substitution represents the ease with which a production factor
substitutes or complements for another in the production process. In particular, a positive sign
indicates substitutability and a negative sign indicates complementarity. The Allen partial
elasticities represent the input elasticities of substitution adjusted for cost share, and as such
allow comparison between inputs with different cost shares.
Furthermore, the own- and cross-price elasticities are calculated in the following manner:
i
iijiiiii S
SSS
−+==
2βσε 4.8a)
i
jiijijjij S
SSS
+==
βσε 4.8b)
i, j = 1, … , n, i ≠ j
Though AES might be the most widely used measure on elasticity of substitution, it is
challenged by Blackorby and Russell (1989) since AES is an appropriate measure of
substitution only in specific cases. As an alternative, Blackorby and Russell demonstrated
that Morishima (1967) elasticity of substitution (MES) has attractive properties not possessed
by the Allen-Uzawa elasticity. The MES is defined as:
iijiijM εε −= and jjijjiM εε −= 4.9)
63
In the recent literature there seems to be no doubt about the superior properties of the MES to
the AES (e.g., Stiroh, 1999; Fleissig and Swofford, 1996; Kant and Nautiyal, 1996). The
basic difference between the MES and the AES is that the MES has inherent asymmetry
while the AES is symmetric. Blackorby and Russell (1989) showed that asymmetry is
natural, as the partial derivative must be evaluated in the direction of the input price that
actually changes. For cost function with more than two inputs, the MES is symmetric if and
only if the cost function is of the constant elasticity of substitution (CES). The asymmetric
property of the MES is critical for this study because the difference, if any, between the
substitution of the US product by the Canadian product and the Canadian product by the US
product will provide some better understanding of the competitiveness of the Canadian
products in the US market.
It is important to note that the substitution elasticities are based on own-price and cross-price
elasticities that are derived from the dual approach. Therefore, the own-price and cross-price
elasticities are so-called compensated elasticities, which means that the elasticities do not
include effects of price changes to the overall level of consumption. Instead, the later two
express the impact of a price change of one factor to the usage of either the same factor or
another factor, and it follows that they do not measure substitutability between pairs of
factors. For this reason, both AES and MES measure pure substitution effects.
4.2.4. Imposing Concavity
A well-behaved cost function is concave in the factor prices, and its factor demand functions
are strictly positive for positive input prices and a positive output level. To ensure this, the
cost function should be monotonically increasing and strictly quasi-concave in input prices
and level of output. As is well known, a necessary and sufficient condition for concavity is
that the Hessian matrix of the cost function be negative semi-definite. It has been found that,
however, the theoretical curvature conditions are frequently not satisfied (Ryan and Wales,
1998) by the estimated cost, profit or indirect utility function. In the case of translog cost
function, no parametric restrictions can ensure concavity, as the property is data dependent. If
64
an estimated cost function fails to be concave, then any inferences based on it are highly
suspect. In this paper, we employ an approach suggested by Ryan and Wales (1998, 2000),
which involves imposing local concavity in the translog form, to make sure that our estimated
cost function is economically well-behaved.
4.3 Estimation
Three assumptions are made in order to estimate the econometric model of pulp and paper
demands in the US. First, the pulp and paper products selected for our study are treated as
either raw materials or intermediate goods; second, pulp and paper use is assumed to be
separable from other inputs; and third, it is assumed that the sub-cost function 4.4) may be
approximated by a translog function form. The translog provides a second-order
approximation to the unknown cost function and it also provides the coefficient estimates
necessary to compute the own- and cross-price elasticities for each of the components of pulp
and paper use.
Though the translog cost function of 4.4) could be estimated directly, the direct estimation of
the translog cost function is not preferred on statistical grounds since the information
contained in the cost shares is neglected in the direct estimation and the large number of
independent variables frequently poses the problem of multicollinearity. Gains in efficiency
can be realized by estimating the cost share equations (Berndt, 1996). We used seemingly
unrelated set of equations using Iterative Zellner-efficient estimation (IZEF) with symmetry
constraints procedure in the estimation, as proposed by Berndt (1996). This method is
equivalent to the maximum likelihood estimation, which ensures that the estimation is
independent of the choice of the equation to be omitted.
The “adding-up” condition of the share equation system ensures that for each observation the
sum of the dependent variables (the cost shares) over all equations is always equal to one. To
avoid the problem of singularity of covariance matrix, one cost share equation was dropped
from the estimation. Since MLE procedure was employed in our study, the parameter
65
estimates are invariant to the dropped equation (Berndt, 1996). Moreover, the parameter
coefficients and their standard errors for the dropped cost share equation were estimated
indirectly.
4.4 Data
Data used in this analysis were collected from two sources: trade data of pulp/paper imports
to the US were from United States International Trade Commission (USITD), while data of
US domestic pulp and paper consumption and prices were from RISI (www.risiinfo.com). All
data were monthly from January 1999 to July 2007. Three pulp/paper products were selected
for our study. They are, respectively, newsprint (Harmonized System Code, or HS Code
4801), light-weight coated paper (or LWC, HS Code 481021), and bleached nonconiferous
chemical woodpulp (or BHKP, HS Code 470329).
Fig. 4.1. Shares of Newsprint by country to total Newsprint consumption in the US
0
0. 1
0. 2
0. 3
0. 4
0. 5
0. 6
0. 7
1999. 01 2000. 01 2001. 01 2002. 01 2003. 01 2004. 01 2005. 01 2006. 01 2007. 01Year
Mark
et s
hare
CA US Ot her
Due to the unavailability of domestic US pulp data, the competitiveness of pulp and paper
products in US market were studied from two aspects: one is the competition among US
offshore suppliers for BHKP; the other is the competition between US domestic suppliers and
the major suppliers from oversees, for newsprint and LWC, respectively. Canada seems the
only supplier of newsprint to the US for many years. Therefore we choose newsprint
66
imported from Canada, newsprint imported from countries other than Canada, and newsprint
produced in the US for our analysis. As to LWC, we examined the substitution between the
US and the major supply countries, i.e., Canada and the rest of other countries. For BHKP,
there are two major suppliers to the US market, that is, Canada and Brazil. Though the US is
the major producer of wood pulp, accounting for 31% in world market in 2006 (FAO, 2007),
the US domestic production and consumption data for BHKP is not available, because most
pulp consumed by US paper mills is transferred internally from vertically integrated pulp
mills (Lee and Ma, 1999). Therefore we can only study the substitutability among imported
BHKP from Canada, Brazil and the rest of other countries.
Fig. 4.2. Shares of BHKP by country to total US imports
0
0. 1
0. 2
0. 3
0. 4
0. 5
0. 6
0. 7
0. 8
1999. 01 2000. 01 2001. 01 2002. 01 2003. 01 2004. 01 2005. 01 2006. 01 2007. 01Year
Mark
et s
hare
CA Br azi l Ot her
The unit import values were calculated through dividing the total import value by total import
volume for each individual supply source, and deflated by US Producer Price Index
(1982=100). Table 4.1 presents descriptive statistics for prices and cost shares for the three
pulp and paper products of interest in the US market, from January 1999 to July 2007. There
is not much difference between average price of newsprint imported from Canada and US
domestic newsprint price, while the average price of newsprint imported from the rest of
other countries is relatively lower. In addition, newsprint imported from Canada is dominant
67
in the US market, which accounts 57% among US total consumption of newsprint. As to
BHKP, Table 4.1 shows that products imported from Canada seem cheaper than that from
Brazil, at average level. However, Brazilian BHKP has the most shares among total US
imports, which is 58%, while Canada accounts for 38%. For LWC, US can satisfy its demand
mostly by its own, since among the total consumptions, LWC from US accounted for 80%.
Fig. 4.3. Shares of LWC by country to total LWC consumption in the US
0
0. 1
0. 2
0. 3
0. 4
0. 5
0. 6
0. 7
0. 8
0. 9
1999. 01 2000. 01 2001. 01 2002. 01 2003. 01 2004. 01 2005. 01 2006. 01 2007. 01Year
Mark
et s
hare
CA Ot her US
Figure 4.1-4.3 further depict how the market shares change for the three pulp and paper
categories over the research period. The US newsprint demand is mainly satisfied by
domestic products and newsprint imported from Canada. The share of Canadian newsprint in
the US is with a minor downward trend since middle of 2002, however it has been remaining
over US newsprint share for the whole sample period. On the other hand, there has been an
upward trend for the market share of US domestic newsprint since 2003. For BHKP, Brazil’s
market share has been over that of Canada during most of the period. When the Brazilian
share increases (decreases), the Canadian share decreases (increases), which implies a kind of
substitution exists between Canadian and Brazilian BHKP. As to LWC, the domestic supplier
seems dominant in the US market. However, there has been a downward trend for US LWC
since 2001, with market share decreased from around 80% in January 2001 to 55% in July
2007. On the other hand, Canada has been steadily gaining market share for its LWC in the
US market, with market share increased from 19% in January 2001 to 30% in July 2007.
68
Table 4.1 Summary statistics of real unit value (1982=100) and cost shares for pulp and paper products in the US market, January 1999 – July 2007
Variable Variable description Mean Standard
deviation
Newsprint: US, Canada, and the rest of other countries (or Other)
PCA Unit import values of Canada, USD/ton, 1982=100 297.05 23.868
PUS US domestic price, USD/ton, 1982=100 291.11 25.959
Poth Unit import values of Other, USD/ton, 1982=100 279.51 32.002
SCA Imports from Canada/US total consumption, % 57.13 0.03
SUS (US production-US exports)/US total consumption, % 40.86 0.03
Soth Imports from Other, % 2.01 0.008
BHKP: US, Canada, and the rest of other countries (or Other)
PCA Unit import values of Canada, USD/ton, 1982=100 229.66 26.442
PBr Unit import values of Brazil, USD/ton, 1982=100 243.82 42.939
Poth Unit import values of Other, USD/ton, 1982=100 284.30 63.022
SCA Imports from Canada/US total import, % 37.78 0.08
SBr Imports from Brazil/US total import, % 58.27 0.07
Soth Imports from Other, % 3.95 0.03
LWC: US, Canada, and the rest of other countries (or Other)
PCA Unit import values of Canada, USD/ton, 1982=100 426.18 58.155
PUS US domestic price, USD/ton, 1982=100 419.20 51.128
Poth Unit import values of Other, USD/ton, 1982=100 436.64 50.812
SCA Imports from Canada/US total consumption, % 21.07 0.06
SUS (US production-US exports)/US total consumption, % 63.91 0.08
Soth Imports from Other, % 15.02 0.06
4.5 Empirical Results
The results of translog cost function including parameter estimates and the own- and cross-
price elasticities estimated from the time series data for the period January 1999 to July 2007
will be discussed in the following sub-sections. All elasticities were computed by substituting
the estimated coefficients and the average values of the actual cost shares into equation 4.7)
69
to 4.9). Some papers use fitted cost shares rather than actual cost shares, however, Anderson
and Thursby (1986) have demonstrated that the estimated elastisities are distributed
asymptotically normal only when actual shares are used. We follow Anderson and Thursby
using the mean of actual cost shares to calculate the elasticity of substitution, and therefore
we expressed the elasticities as means of time period 1999:1 – 2007:7.
The parameter estimates and cost shares have variances and co-variances, hence the
estimated elasticities also have stochastic distributions. Considering these elasticities are
highly nonlinear functions of the estimated parameters (Berndt, 1996), researchers have
preferred not to calculate the variances of these elasticities, even though methods have been
developed to do the relevant estimation (Berndt and Christensen, 1973; Christensen and
Greene, 1976; and Martinello, 1985).
4.5.1 Parameter estimates
Cost share equations of 4.5) were estimated, with parametric restrictions 4.6). Table 4.2 – 4.4
report the estimated cost share function coefficients and their standard errors. The function is
linear homogeneous in input prices because of the restriction 4.6) imposed on equation 4.5).
A well-behaved cost function is concave in the factor prices, and its factor demand functions
are strictly positive for positive input prices and a positive output level. For monotonicity, the
cost function must be non-decreasing in input prices, which requires that the fitted shares be
positive at each observation. The reported model shows that the fitted shares are non-negative
at all points, and sum to one. For concavity, however, the estimated cost share function of
newsprint and LWC fail to be concave. We therefore report estimated parameters with
imposing concavity by Ryan and Wales (1998, 2000) method.
Table 4.2 –4. 4 report results from estimations of the cost share functions. Casual inspection
of the estimated coefficients shows a high degree of statistical significance for most
coefficients. Since individual coefficients do not have the usual economic interpretation, we
will focus our discussions based on estimated elasticities. Table 4.5 – 4.8 present the
70
estimated elasticities, with diagonal elements being the own-price elasticities and the off-
diagonal elements being the cross-price elasticities.
Table 4.2 Parameter estimates of the Translog Cost Function for Newsprint, among Canada, US, and the rest of other countries, Jan. 1999 – July 2007
Parameter estimation Variables Parameter
estimate Std. error
Cost share equation: Canada
Intercept β 1 0.567*** 0.01
LnPca β cc 0.316*** 0.08
LnPus Βcu -0.308*** 0.08
LnPoth β co -0.008 0.02
Cost share equation: US
Concept β 2 0.408*** 0.01
LnPca β uc -0.308*** 0.08
LnPus Βuu 0.278*** 0.08
LnPoth β uo 0.03** 0.02
Cost share equation: Other
Concept β 3 0.026*** 0.00
LnPca β oc -0.008 0.02
LnPus Βou 0.03*** 0.02
LnPoth β oo -0.022*** 0.01
*** Significant at 1% level ** Significant at 5% level
4.5.2 Elasticities of Substitution
The elasticity of substitution can be interpreted as a measure of competition between a given
set of factors. In case of a ‘high’ elasticity of substitution the factor inputs easily substitute
and therefore compete, and vice versa in case of a ‘low’ elasticity of substitution. As stated
earlier, we use both the AES and the MES (reported in parentheses). In addition to analyze
the elasticities by means, we further examine how substitution elasticities change over time.
71
Table 4.3 Parameter estimates of the Translog Cost Function for BHKP, among Canada, Brazil, and the rest of other countries, Jan. 1999 – July 2007
Parameter estimation Variables Parameter
estimate Std. error
Cost share equation: Canada
Intercept β 1 0.384*** 0.01
LnPca β cc 0.123*** 0.05
LnPbra β cb -0.123*** 0.04
LnPoth β co -0.008 0.02
Cost share equation: Brazil
Concept β 2 0.574*** 0.01
LnPca β bc -0.123*** 0.04
LnPbra β bb 0.105*** 0.04
LnPoth β bo 0.018 0.02
Cost share equation: Other
Concept β 3 0.042*** 0.00
LnPca β oc -0.008 0.02
LnPus β ob 0.018 0.02
LnPoth β oo -0.019* 0.01
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level
Pulp Product - BHKP
Table 4.5 reports elasticity of substitution for BHKP. Both AES and MES have positive signs
for cross elsticities, while all of the estimates are negative for own elasticities. In some cases,
the MES are quite different than the AES, for example the MES of the Canadian BHKP by
BHKP from other countries and the MES of the BHKP from other countries by the Canadian
BHKP are quite different than their respective AES, and also the two MES are not equal.
Hence, we will draw our inferences based on the MES, and the AES are given just for
information.
72
Table 4.4 Parameter estimates of the Translog Cost Function for LWC, among US, Canada,
and the rest of other countries, Jan. 1999 – July 2007 Parameter estimation Variables Parameter
estimate Std. error
Cost share equation: Canada
Intercept β 1 0.167*** 0.01
LnPca β cc 0.463*** 0.07
LnPus Βcu -0.532*** 0.07
LnPoth β co 0.069* 0.04
Cost share equation: US
Concept β 2 0.735*** 0.01
LnPca β uc -0.532*** 0.07
LnPus Βuu 0.317*** 0.10
LnPoth β uo 0.215*** 0.06
Cost share equation: Other
Concept β 3 0.098*** 0.01
LnPca β oc 0.069* 0.04
LnPus Βou 0.215*** 0.06
LnPoth β oo -0.285*** 0.06
*** Significant at 1% level
** Significant at 5% level
* Significant at 10% level
The highest substitution in BHKP imports exists between Brazil and the rest of other
countries (Other thereafter). Further, we found that the BHKP from Other is easy to be
substituted by BHKP from Canada (with MES of 1.48) or by BHKP from Brazil (with MES
of 1.51). On the other hand, though Canada and Brazil are the two major suppliers in the US
market, only weak substitution exists between them (0.46 of Canada by Brazil, and 0.49 of
Brazil by Canada). Moreover, Brazilian BHKP is easier to be substituted by the BHKP from
Other (with substitution elasticity of 1.29,), than be substituted by Canadian BHKP (with
substitution elasticity of 0.49). Therefore, the competition between Canada and Brazil is not
so much as the competition Brazil is facing from the Other, and Canada has a comparative
73
advantage in terms of substituting pulp from Other as compared to substation of the Canadian
pulp by Other.
Table 4.5. The estimated Allen and Morishima elasticities for BHKP, Jan. 1999 to July 2007
Canada Brazil Other
Canada -0.78648 0.440366
(0.463504)
1.026804
(0.68506)
Brazil 0.440366
(0.494135)
-0.40764 1.803766
(1.288588)
Other 1.026804
(1.478274)
1.803766
(1.508964)
-36.3979
Note: the Morishima elasticity of substitution is in parentheses. The row and column represent numerator and denominator,
respectively. For example, the elasticity of substitution of Canada by Brazil is in the row corresponding to Canada and the
column corresponding to Brazil.
Fig. 4.4. MES change for Canadian BHKP, 1999 - 2001
0
0. 1
0. 2
0. 3
0. 4
0. 5
0. 6
0. 7
0. 8
1999 2000 2001 2002 2003 2004 2005 2006 2007year
elas
tici
ty o
f su
bsti
tuti
on
Canada by Br azi l Canada by ot her count r i es
Fig. 4.4 depicts the MES change for both Canada by Brazil and Canada by Other. The trend
is relatively stable. It seems that in the US market, the competition between the Canadian
BHKP and other US offshore suppliers has not changed much during the sample period.
There is even a minor decline of substitutability during 2002 and 2006, for both Canada by
Brazil and Canada by Other. However, with the exclusion of BHKP data from US, which is
the largest pulp producer in the world, and may have influence on the competitive position of
its imported products, our findings should be viewed with some caution.
74
Table 4.6. The estimated Allen and Morishima elasticities for newsprint, Jan. 1999 to July
2007
Canada US Other
Canada -0.17837 0.382699
(0．337924)
-0.75238
(-0.34572)
US 0.382699
(0．24871)
-0.22016 -5.63535
(-2.23406)
Other -0.75238
(0.023151)
-5.63535
(-0.07612)
-1.89116
Note: the Morishima elasticity of substitution is in parentheses. The row and column represent numerator and denominator,
respectively. For example, the elasticity of substitution of Canada by US is in the row corresponding to Canada and the
column corresponding to US.
Newsprint
The results in Table 4.6 report both AES and MES. All own elasticities of substitution have
negative signs but all cross elasticities are not positive which means Newsprint from different
sources need not to be substitutes. However, the MES values provide many interesting
results. First, the Canadian and the US newsprint are substitutes, and the MES for Canada by
US (0.34) is slightly higher than the MES for US by Canada (0.25) which means that the
substitutability of the Canadian newsprint by the US newsprint is slightly higher than the
substitutability of the US newsprint by the Canadian newsprint. Second, the MES of the
Canadian newsprint by newsprint from other countries is negative (-0.35), and the MES of
the US newsprint by newsprint from other countries is also negative and much higher (-2.23).
These results indicate that most likely the newsprint from other countries is of different
quality, and probably of poor quality, and this newsprint is being used in combination with
the US and the Canadian newsprint. For example, some newspapers use different quality
paper for different sections. Third, the MES of the newsprint from other countries by the
Canadian newsprint is positive but very small (0.02) but the MES of newsprint from other
countries by the US newsprint is negative and small (-0.08). These values indicate that a
small faction of the newsprint from other countries (about 2%) can be substituted by the
Canadian newsprint. In summary, these MES values indicate that in the newsprint market of
75
the US, the Canadian competition is with the US producers and not with the producers from
other countries.
Fig. 4.5. MES between US and Canadian newsprint, 1999 - 2001
0
0. 05
0. 1
0. 15
0. 2
0. 25
0. 3
0. 35
0. 4
1999 2000 2001 2002 2003 2004 2005 2006 2007year
elas
tici
ty o
f su
bsti
tuti
on
Canada by US US by Canada
It is particular interesting to note that how the substitution between Canada and the US
changed during the sample period, which is presented in Fig. 4.5. The elasticity of
substitution (MES) has been quite stable over the research period, with MES of Canada by
the US changes from 0.3 to 0.33, and MES of US by Canada ranges from 0.19 to 0.26.
Though Canadian pulp and paper industry are facing challenges like strong Canadian dollar,
it seems there is no major change of substitutability for Canadian newsprint, and therefore the
Canadian newsprint still keeps its competitive position in the US market. In fact, the MES of
US by Canada has improved since 2004, which is a good sign for the Canadian producers.
However, the question is that how can we explain the shut-downs in the Canadian newsprint
industry for the past several years? We think it is because the demand for newsprint is
declining in US market. As shown in Fig. 4.6, apparent consumption of newsprint in the US
has been continuously decreasing since 2001, and US imports from Canada has also
decreased accordingly.
LWC
Table 4.7 reports the AES and the MES for LWC, and the results are similar to newsprint. On
the basis of the MES values, we can draw three inferences. First, the Canadian and the US
LWC are substitutes, and the MES of the Canadian LWC by the US LWC (1.64) is slightly
76
lower than the MES of the US LWC by the Canadian LWC (1.72). However, in both cases
the MES for LWC are much higher than the respective MES for newsprint or LWC is elastic
while newsprint is inelastic. Second, the LWC from other countries and the US LWC are also
substitutes, while the newprint from these two sources were complements. The MES of the
US LWC by LWC from other countries (0.43)) is slightly higher than the MES of LWC from
other countries by the US LWC (0.35), but these values of the MES are much lower than the
MES values between the US and the Canadian LWC. Third, the MES of the Canadian LWC
by LWC from other countries is positive (0.69) while the MES of LWC from other countries
by the Canadian LWC is negative but much smaller (-0.04). In summary, these MES values
indicate that the US LWC market is quite different than the US newsprint market. In this
market, other countries are also competing with Canada, and those countries can substitute
the Canadian LWC while Canada cannot substitute their LWC. However, the elasticities of
substitution between the Canadian LWC and the US LWC are very high, and Canada has a
slight advantage in terms of substituting the US LWC as compared to the US LWC
substituting the Canadian LWC.
Fig. 4.6. Apparent consumption of newsprint in the US market
0
200000
400000
600000
800000
1000000
1200000
1999. 01 2000. 01 2001. 01 2002. 01 2003. 01 2004. 01 2005. 01 2006. 01 2007. 01year
metr
ic t
ons
i mpor t s f r om Canada Tot al consumpt i on
The changes of MES for both Canada by US and US by Canada are represented in Fig.4.7.
Fig. 4.7 leaves no doubt that the MES of the US by Canada change over time, while the MES
of Canada by the US is rather stable. For the MES of the US by Canada, there is an upward
77
trend since 2002 and substitutability reaches the highest at year 2005. However, it is
interesting to note that since then a downward trend has happened. It seems there is no major
change for the competitiveness position of the Canadian LWC, while for the US LWC, it is
less competitiveness than that of Canada’s, because of its higher elasticity.
Table 4.7. The estimated Allen and Morishima elasticities for LWC, Jan. 1999 to July 2007
Canada US Other
Canada -5.42278
2.29155
(1.640951)
-2.16863
(0.692205)
US 2.29155
(1.72012)
-0.37396
0.431773
(0.519959)
Other -2.16863
(-0.04211)
0.431773
(0.352537)
-1.89116
Note: the Morishima elasticity of substitution is in parentheses. The row and column represent numerator and denominator,
respectively. For example, the elasticity of substitution of Canada by US is in the row corresponding to Canada and the
column corresponding to US.
Fig. 4.7. MES between US and Canadian LWC, 1999 - 2001
0
0. 5
1
1. 5
2
2. 5
3
3. 5
1999 2000 2001 2002 2003 2004 2005 2006 2007year
elas
tici
ty o
f su
bsti
tuti
on
Canda by US US by Canada
4.5.3 Price Elasticities of Demand
In order to analyze the price responsiveness of individual product, we present in Table 4.8
empirical estimates of the own and cross-price elasticities of demand calculated according to
equations 4.8a) and 4.8b). All the own-price elasticities, which are shown on the diagonal,
have the correct sign.
78
For BHKP, demand for both Canadian and Brazilian pulp are price inelastic, while the
demand for BHKP imported from other countries is price elastic. Specifically, a 1% decrease
(increase) in Other’s price increases (decreases) market demand by 1.44% which suggests
that Other countries can expand their market share in the US with a price reduction
mechanisms. Since, the MES of the Brazilian BHKP by Other’s BHKP (1.29) is much higher
than the MES of the Canadian BHKP by Other’s BHKP (0.69), Brazil is more susceptible to
competition from other countries in the US market. However, Canada can also face the music
of competition from other countries because MES of 0.69 is not negligible.
Table 4.8. Own- and cross-price elasticities of demand for pulp and paper products, US, Jan. 1999 to July 2007
Newsprint For a 1% change in the price of Percentage effect on the
quantity demand of Canada US Other
Canada -0.10743 -0.61995 -0.0153
US -0.90507 -0.09083 -0.11456
Other -0.45315 -2.32488 -0.03845
BHKP For a 1% change in the price of Percentage effect on the
quantity demand of Canada Brazil Other
Canada -0.29713 0.256602 0.040559
Brazil 0.16637 -0.23753 0.071249
Other 0.387927 1.051054 -1.43772
LWC For a 1% change in the price of Percentage effect on the
quantity demand of Canada US other
Canada -1.1535 1.478795 -0.32912
US 0.487446 -0.24132 0.065528
Other -0.4613 0.278634 -0.28701
The US demand for newsprint, from all three sources (Canada, US, and other countries), is
inelastic with respect to own prices, and own price elasticites are very small Canada (-0.11),
the US (-0.09), and other countries (-0.04). However, the impact of change in the prices of
the US newsprint is quite interesting: 1% increase in the US newsprint price will increase the
demand of Canadian newsprint by 0.16% and it will decrease the demand of newsprint from
79
other countries by 2.33%. The demand of the Canadian newsprint is almost insensitive to
price change in newsprint from other countries while 1% increase in the Canadian newsprint
price will decrease the demand of newsprint from other countries by 0.45%.
In the case of the US demand for LWC, only demand for the Canadian LWC is own-price
elastic while the demand for the US LWC and LWC from other countries is own-price
inelastic. A 1% increase in the price of the US LWC results in an increase of 1.48% in the
quantity demanded of Canadian LWC, and 0.28% in the quantity demanded of LWC from
other countries. On the other hand, a 1% increase in the price of LWC from other countries
results in an increase of 0.07% in the quantity demanded of the US LWC, 0.33% decrease in
the quantity demanded of the Canadian LWC and 0.29% decrease in the quantity demanded
of LWC from other countries. Hence, the US demand for the Canadian LWC is highly
sensitive to the price of the Canadian LWC and the US LWC but not so sensitive to the price
of LWC from other countries.
4.6 Discussion
On a global scale, pulp and paper products are big business that concerns the welfare of
millions of people in many parts of the world. Most existing econometric studies of pulp and
paper industry use aggregate data, and address the issues from supply side. The analysis of
demand side is as important as the analysis of supply side for having a better understanding
of the competitiveness of any industry. An important question from the demand side is: what
is the substitutability of domestic pulp and paper products by imported pulp and paper
products, and of imported products from one country by imported products from other
countries? For this reason the elasticity of substitution is particularly relevant for policy
applications. It allows for the understanding of how regulatory measures may affect the usage
of factor inputs. This paper presents the analyses of substitutability of three Canadian pulp
and paper products (BHKP, newsprint, and LWC) and other suppliers in the U.S. market.
80
We found that the use of AES, for understanding the substitution between products from
different countries is questionable, and the MES provides more meaningful results. Second,
the substitution relationships, in the same market, can be quite different for pulp products and
paper products, as we found quite different substitution relationships for the BHKP as
compared to newsprint and LWC. Third, the substitution relationships, in the same market,
can also be quite different, even for different types of paper products as we found that the
substitution relationship for newsprint is quite different than that that of LWC.
Our key findings are: i) in the US BHKP market, the competition between Canada and Brazil
is low while Brazil is facing tough competition from other countries, and Canada has a
comparative advantage in terms of substituting pulp from other countries as compared to
substitution of the Canadian pulp by other countries. Moreover, the demand of the Canadian
BHKP is price inelastic and elasticity of substitution for the Canadian BHKP is relatively
stable over the sample period. (ii) in the US newsprint market, there is a weak substitution
between the Canadian and the US newsprint, and the demand for newsprint, from all sources,
are price inelastic. Hence a change in the price of Canadian newsprint does not trigger a
large response in the quantity demanded by the US market. In addition, demand for the
Canadian newsprint is not affected by the price changes either for the US newsprint or for
newsprint from other countries. It seems the competitive position of the Canadian newsprint
in the US has been maintained because there is no major change of substitutability for
Canadian newsprint during the research period, and iii) the Canadian LWC is a substitute for
and directly competes with the US LWC, which is demonstrated by the relatively high degree
of substitution between the US and the Canadian LWC. Furthermore, the asymmetry of the
MES highlights that if both Canada and the US employ pricing strategy to increase their
market share, the Canadian LWC seems to have more advantage if the price changes in the
same rate for LWC from two countries. In addition, the Canadian LWC has an elastic own-
price elasticity, which suggests that increasing production efficiency, and lowering costs, may
be one effective means for improving the Canadian LWC’s export performance in the US
market.
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Based on these results, it appears that Canadian pulp and paper products have maintained
their competitiveness in the US market. Our findings are in analogue with previous studies,
e.g., Oum et al. (1991), that address the productivity (supply-side) of the Canadian pulp and
paper industry to its counterparts. Most of the supply-side studies found higher productivity
growth in the Canadian pulp and paper industry for the period they studied. However, none of
those studies use recent data for relevant analysis. The most recent study is by Hseu and
Shang (2005). Hseu and Shang found that the productivity of the Canadian pulp and paper
industry increased by 2% from 1991 to 2000, while that of its United States counterpart
increased only by 0.8%. The Canadian productivity growth is also higher than that of Nordic
countries, which are from 1.2 to 1.5%. Therefore, our study complements these studies which
focused on supply-side.
The Canadian pulp and paper industry, however, has been going through a hard time for the
past few years, for example, there is a massive newsprint capacity cuts in Canada
(www.pulpandpaper.net, 2007). As per our results this is not because the loss of its product
competitiveness in the US market, and as per supply-side studies, it may not be due to loss in
our productivity. Instead, it is more likely due to other reasons such that demand for paper
products is in structural decline in the US. For example, the substitution of paper by
computers may be a key reason, and newsprint has been worst hit by competition from
broadcasting and internet, both in the sphere of information and in the sphere of advertising.
Yet the structural decline is far from universal and is predominantly confined to mature
markets like the US. In addition, cyclical factors such as the surging Canadian dollar are
detracting from the industry’s performance, since most of its costs, including energy,
material, and labor costs, are in Canadian dollars, while the industry’s revenue is in U.S.
dollars. Considering Canada’s pulp and paper export has heavily relied on the demand from
US for many years, with more than 60% of its pulp and paper exports are destined to the US
(PPPC, 2005), the fortune of the Canadian pulp and paper industry is highly dependent on the
demand from the US market. The weak dollar and consecutive falling demand for newsprint
and other paper products in the US has brought the hard time for its major exporter, Canada.
Moreover, as a mature market for pulp and paper, the US market does not leave much space
82
for further development. In order to remain competitive and retain a dominant position in the
world market place, the Canadian pulp and paper industry will have to create global reach
and develop new markets.
In conclusion, this paper provides observations regarding market behavior of the Canadian
pulp and paper products in the US market, and the findings are useful to identify the
challenges facing the Canadian industry. However, there are many more insights to be gained
in future studies. First, the current study is based on limited data of a few pulp and paper
products. Second, the results may be sensitive to the functional form of cost function. Third,
the analyses presented in this paper cover only the demand side, and the study does not cover
many other dimensions of competitiveness such as supply side (for the recent data), firm’s
strategy, supporting industry, and macro-economic factors. To get a complete understanding
of the competitiveness of the Canadian pulp and paper industry, these issues need to be
studied in future research. Finally, the results of this study do not provide insight how the
competitive position be acquired, and how that position could be maintained in the future.
Nevertheless, the study contributes new and interesting insights into the US market of pulp
and paper products and the relative competitive position, from demand side, of the Canadian
products in that market. Specifically, the employment of sound econometric tools in this
study provides robust results that allow one to compare and contrast market behavior for pulp
and paper market in North America.
83
CHARPER V
CONCLUSIONS AND POLICY IMPLICATIONS
5.1 General Conclusion
The pulp and paper industry, being a significant contributor to the global economy, has
attracted numerous studies that explore its economic characteristics. Pulp and paper are two
of the largest in the forest products trade (Chao and Buongiorno, 2002) and therefore, an
understanding of market integration and dynamic market linkages of the joint market is
critical for designing relevant policies especially when the regional market is important. In
this thesis, a detailed in-depth analysis of market integration and dynamic market linkages of
pulp and paper product markets in North America is conducted. In addition, in view of the
Canada-US free trade agreement and the general trend of liberalizing international trade, the
future of Canada’s export-driven pulp and paper industry depends heavily on its market
performance. Canadian forest industry is currently facing many challenges like increasing
costs, appreciation of the Canadian dollar, growth in offshore competition and constraints to
the fibre supply7. Measuring the competitiveness of Canadian pulp and paper products in the
US market will provide a valuable and strong base of information to the government for
launching long-term competitiveness initiatives. On the basis of these results, the following
general conclusions can be drawn.
First, market integration does not exist in five regional newsprint markets of North America
(i.e., British Columbia, Ontario, Quebec, US east, and US west) during the research period,
neither does the LOP hold for any pair of Canadian markets, nor for the pairs between US
and Canadian markets. However, the LOP is valid in the two US newsprint markets. These
7 According to North American Wood Fiber Review (available at http://www.pr.com), there are reduced supplies of residual chips from a struggling sawmilling sector. Meanwhile, wood chip prices have increased by over 15% in Canada since the first quarter of 2007.
84
results imply that there is no single newsprint market in North America but several regional
ones, and there appears to be a single US market for newsprint.
Second, among the two US newsprint markets, changes in supply or demand in one market
affect the price and (or) volume of transactions in the other. In particular, it seems that the US
east price is the determining part and US west price is the adjusting part.
Third, the US import market for pulp and paper products seems to have strong market
integration among its suppliers. In addition, system-wide shocks could be absorbed
effectively and efficiently by the market, especially for BHKP, LWC, and a new equilibrium
could be reached quickly after a shock. While adjustment for Kraftpaper takes a relatively
longer period, comparing the time taken for BHKP and LWC, it appears that Kraftpaper has a
lower degree of integration than that for BHKP and LWC in the US market.
Fourth, the US pulp and paper market is not dominated by its import market. On the other
hand, however, the US market for LWC and BHKP seems to take the leadership in terms of
price changes, since shocks to the US domestic prices are important in accounting for
fluctuations in relevant import prices. We also note that the US market is somewhat isolated
for imported Kraftpaper, i.e., neither the price for US domestic produced Kraftpaper be
affected by that of imported Kraftpaper, nor does the change of US Kraftpaper price lead to
price change of imported Kraftpaper.
Fifth, it appears that Canadian pulp and paper products are competitive in the US market.
There is no substitution between newsprint products from Canada and other countries.
Though Canada has been the major supplier of newsprint to the US for many years, only a
weak substitution exists between US and Canada. As for BHKP, Canada and Brazil are the
two major suppliers, the substitution between Canadian and Brazilian BHKP is weak. In
addition, a strong substitution exists between Canadian BHKP and the BHKP imported from
other countries. However, it is easier to substitute BHKP from other countries to Canadian
BHKP than the other way around. In terms of LWC, there is a strong substitution between US
and Canada, and very little difference between the degree of substitution for Canada by US
85
and that for US by Canada. Our findings suggest that Canadian LWC is a substitute for and
directly competes with US LWC.
Sixth, the study of substitution over the research period further indicates that Canadian pulp
and paper products have maintained their competitiveness in the US market for the past
years. There is no major change of substitutability for Canadian newsprint and Canadian
BHKP in the US market for the past years. Though Canadian pulp and paper industry is
facing the challenges from the surging Canadian dollar, it seems the competitive position of
its newsprint and BHKP has not been affected much, at least in the short term. As for
Canadian LWC, though its competitiveness seems to be eroded between 2002 and 2006, it
has successfully regained its competitive position since 2006.
Seventh, the demand for newsprint is overall price inelastic in the US market, which suggests
that the US demand for newsprint does not change much when price changes. In addition,
demand for Canadian newsprint is not affected by the price changes either for US newsprint
or for Other newsprint. Similarly, a change in the price of Canadian BHKP also does not
trigger a large response in the quantity demanded by US paper industry. In the mean time,
either a change in Brazilian BHKP price or in Other BHKP price does not affect US demand
for Canadian BHKP. As to Canadian LWC, however, it is price elastic in the US market,
which suggests that Canadian LWC is expected to gain more market shares in the US by
appropriate marketing strategies. Moreover, US price change will have influence on the
demand for Canadian LWC.
5.2 Policy Implication
Forest product consumers and producers respond not only to prices but also to policies. This
is so because prices are directly linked to policies, since forest policies impact input and
output prices by influencing the supply and demand for inputs and outputs. This thesis
examines the market structure of pulp and paper in North America, and brings new insights
into how pulp and paper products compete in the US market. Policy implications are made on
the basis of the three essays:
86
First, the results of market integration for newsprint indicate that though the US newsprint
markets could be regarded as a single market, overall newsprint markets in North America
could not be modeled simultaneously, nor could the Canadian newsprint market be treated as
a single market. However, in international trade literature related to newsprint, the results of
some of the trade models and welfare implication studies have been based on the assumption
of market integration, which were not found in this research. Policy makers should use the
results of those trade models cautiously.
Second, it is proper for Canada to have its independent provincial policy regarding its
newsprint industry, since provincial policy changes are not expected to have direct impact on
overall markets in Canada or the United States.
Third, a comparison of the results of the degree of market integration for LWC, BHKP and
Kraftpaper shows that, the time taken to absorb a system-wide shock is least for BHKP, and
any shocks in Kraft paper take a longer time to return to the equilibrium level. Therefore the
policy makers should be cautious when they induce any shock to those markets that might be
at risk for price volatility.
Fourth, since the prices for LWC and BHKP are tied more closely with corresponding US
prices, and US prices further lead the price changes for LWC and BHKP. Policy makers at
the micro or industrial level need to give more attention to those products that might be
affected due to relevant policy or structure changes in the US market.
Fifth, the competitiveness of Canadian pulp and paper products has not deteriorated in the US
market, especially for newsprint and BHKP. We therefore conclude that the decline in
demand for Canadian pulp and paper products is not because Canada is losing its
competitiveness in the US market. Instead, it is mainly because the demand for newsprint is
in structural declines in US market. Given that more than 60% of Canadian pulp and paper
exports are destined to the U.S.A, the fortune of Canadian pulp and paper industry will rely
heavily on the demand from US market. Nowadays demand for many grades of paper has
been declining in North America, and newsprint has been worst hit due to the sharp shift to
87
digital media for advertising. Policy makers should note that market opportunities are
changing significantly. While the North American market for pulp and paper is shrinking, the
markets in developing regions are quickly expanding, which constitute an interesting
opportunity for Canadian pulp and paper industry. Policy makers therefore need a rethinking
of market strategy and company supply chain structures.
Sixth, industry executives and public policymakers who use forecasts based on the models for
the whole industry need to be aware that sub-segments of the industry respond differently to
changes in prices and policies than the whole industry and thus distort existing forecast
accuracy.
5.3 Suggestions For Future Research
The pulp and paper industry remains an important Canadian industry and one with leading
global export share. It will keep contributing to a high and rising standard of living if it can
maintain and strengthen its competitiveness in world market.
In terms of current analysis, there remains much insight to be gained in further study. First,
the study is based on limited data of a few pulp and paper products. Second, the models used
in the study do not identify the determinants of the degree of market integration. Third, the
results of the competitiveness analysis do not provide insight how the competitive position be
maintained, which is a question can only be answered from supply side. Nevertheless, the
author believes that the current study contributes new and interesting insights to the trade in
pulp and paper products. Specifically, the employment of advanced econometric models in
this study provides robust results that allow one to compare and contrast structure, dynamic
linkages and market behavior for pulp and paper market in North America.
88
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