Import-as-Market-Discipline in Production Import-as-Market-Discipline in Production Networks: Evidence of Thai Manufacturing SectorNetworks: Evidence of Thai Manufacturing Sector

Archanun KohpaiboonArchanun Kohpaiboon

Faculty of Economics, Thammasat University and Faculty of Economics, Thammasat University and

and and

Juthathip Jongwanich,Juthathip Jongwanich,

School of Management, Asian Institute of School of Management, Asian Institute of TechnologyTechnology

IssuesIssues How firms change their pricing behavior in response How firms change their pricing behavior in response

to threat from imports remains interesting to the to threat from imports remains interesting to the international economics literature. international economics literature.

Generally, imports can force firms to set price Generally, imports can force firms to set price competitively and improve the efficient use of limited competitively and improve the efficient use of limited resources. resources.

The effect of import on price setting behavior is The effect of import on price setting behavior is known as known as import as a market discipline hypothesisimport as a market discipline hypothesis (Levinsohn,1993). (Levinsohn,1993).

What makes the issue interesting is the mixed What makes the issue interesting is the mixed outcome in empirical studies.outcome in empirical studies.

Negative relationshipNegative relationship- Esposito & Esposito (1971)Esposito & Esposito (1971)- Pagoulatos & Sorensen Pagoulatos & Sorensen

(1976)(1976)- Pugel (1980) Pugel (1980) - Lyons (1981)Lyons (1981)- Geroski (1982)Geroski (1982)- Neuman et al. (1984)Neuman et al. (1984)- Chou (1986)Chou (1986)- De Ghellinck De Ghellinck et al.et al. (1988); (1988);

Levinsohn (1993)Levinsohn (1993)- Katies & Peterson (1994) Katies & Peterson (1994)

Positive relationshipPositive relationship

- - Urata (1979); Urata (1979);

- Pagoulatos & Sorensen - Pagoulatos & Sorensen (1981)(1981)

- Nolle (1991)- Nolle (1991)

- Ståhlhammer (1991, 1992) - Ståhlhammer (1991, 1992)

- Field & Pagoulatos (1994).- Field & Pagoulatos (1994).

Interestingly, since 1990 global production network has Interestingly, since 1990 global production network has gained its relative importance gained its relative importance in global trade, reflecting in global trade, reflecting by the rapid expansion of trade in parts and components by the rapid expansion of trade in parts and components (Athukorala, 2011).(Athukorala, 2011).

Intermediates like parts and components traded under the Intermediates like parts and components traded under the production network are production network are far different from those traded in far different from those traded in the arms’ length transaction. the arms’ length transaction.

Sometimes, we cannot be noticed by its appearanceSometimes, we cannot be noticed by its appearance (reflected by serial numbers), e.g. specific integrated (reflected by serial numbers), e.g. specific integrated circuits jointly developed between Celestica and circuits jointly developed between Celestica and Panasonic for Flat screen TVs (Kohpaiboon, 2011). Panasonic for Flat screen TVs (Kohpaiboon, 2011).

ExamplesExamples

Stage 1

Stage 2

Stage 3

Stage 5Stage 4

Country A

Country B

Country C

Country D

Example: Apple iPhone 3GExample: Apple iPhone 3G

Y-O-Y Export Growth (%)Y-O-Y Export Growth (%)

Given such difference, therefore, the effect of import on Given such difference, therefore, the effect of import on firms’ price setting behavior would be different between firms’ price setting behavior would be different between network and non-network trade. network and non-network trade.

This issue is This issue is highly policy relevant highly policy relevant for developing for developing

countries which are still reluctant to continue trade countries which are still reluctant to continue trade liberalization (e.g. selective approach and rely on tariff liberalization (e.g. selective approach and rely on tariff exemption/rebate schemes) as well as in a period of a rise exemption/rebate schemes) as well as in a period of a rise of protectionism threat amidst the global economic of protectionism threat amidst the global economic recession.recession.

Evidence of gains from trade liberalization is still needed.Evidence of gains from trade liberalization is still needed.

PaperPaper

Examine the import-as market discipline hypothesis in Examine the import-as market discipline hypothesis in Thai manufacturing with a hypothesis of possible Thai manufacturing with a hypothesis of possible different effect of fragmentation-driven parts and final different effect of fragmentation-driven parts and final goods imports, using the latest available industrial goods imports, using the latest available industrial census (2006) is used. census (2006) is used.

Thai manufacturing has long experience participating in Thai manufacturing has long experience participating in the production network. the production network.

Thailand still has high nominal protection by the Thailand still has high nominal protection by the regional standards (Jongwanich & Kohpaiboon, 2007).regional standards (Jongwanich & Kohpaiboon, 2007).

Analytical FrameworkAnalytical Framework The effect of import on price setting behavior (how different The effect of import on price setting behavior (how different

between price and marginal cost) is based on the fact that between price and marginal cost) is based on the fact that imports and domestically produced goods are close imports and domestically produced goods are close substitutessubstitutes. .

The more the imports, the greater the pressure on price The more the imports, the greater the pressure on price narrowing a gap between price and marginal costs. It is narrowing a gap between price and marginal costs. It is unlikely for firms to set price far above marginal costs (i.e. unlikely for firms to set price far above marginal costs (i.e. improve efficient use of resources).improve efficient use of resources).

As argued in Lopez and Lopez (1996), As argued in Lopez and Lopez (1996), the net effect depends the net effect depends on the oligopolistic response of firms to changes in imports on the oligopolistic response of firms to changes in imports

In some cases where domestic firms cut their output in In some cases where domestic firms cut their output in response to import surges, the net effect on price would response to import surges, the net effect on price would be less.be less.

Our core hypothesis in this paper is a possible different Our core hypothesis in this paper is a possible different effect of fragmentation-driven parts imports as opposed effect of fragmentation-driven parts imports as opposed to final good imports.to final good imports.

The disciplining effect of import would be stronger in The disciplining effect of import would be stronger in the network tradethe network trade (the network import has stronger (the network import has stronger effect in narrowing the gap between price and marginal effect in narrowing the gap between price and marginal cost).cost).

Given the fact that developing countries have strong belief Given the fact that developing countries have strong belief in cascading tariff structure to promote local production, in cascading tariff structure to promote local production, type of import goods would be dominated by intermediates type of import goods would be dominated by intermediates used for finished goods productionused for finished goods production. It would be difficult to . It would be difficult to find close substitute products in domestic market. The find close substitute products in domestic market. The expected disciplining effect would be limited. expected disciplining effect would be limited.

It is possible to have finished goods imports but they are It is possible to have finished goods imports but they are likely to be totally different from locally manufactured likely to be totally different from locally manufactured ones. As reflected in the previous studies (Kokko, 1994; ones. As reflected in the previous studies (Kokko, 1994; Moran, 1998), high nominal protection encourages the entry Moran, 1998), high nominal protection encourages the entry of local enterprises but they might focus certain niches that of local enterprises but they might focus certain niches that are not directly competing with imports. are not directly competing with imports.

By contrast, in the production network, the disciplining By contrast, in the production network, the disciplining effect would be stronger. effect would be stronger.

Decision to fragment the whole production process\(in-Decision to fragment the whole production process\(in-house vs. outsourced), where to be produced (home vs. house vs. outsourced), where to be produced (home vs. aboard) is systematically determined to ensure the cost aboard) is systematically determined to ensure the cost competiveness of final goods. competiveness of final goods.

Hence, oligopolistic responses like change output level Hence, oligopolistic responses like change output level in responses to import changes are less likely to work in in responses to import changes are less likely to work in the network trade. the network trade.

Regard to the disciplining effect (pressure on prices) Regard to the disciplining effect (pressure on prices) competition found at the final goods between leading MNEs competition found at the final goods between leading MNEs can easily pass through to each stage of production in the can easily pass through to each stage of production in the network. network.

Inefficiency occurring in any stage of production can create Inefficiency occurring in any stage of production can create significant impact on final goods competitiveness. It is in line significant impact on final goods competitiveness. It is in line with the effect of tariff on production network (Yi, 2003). with the effect of tariff on production network (Yi, 2003).

Hence, firms in the networks must work together to ensure all Hence, firms in the networks must work together to ensure all non-price qualifications are fulfilled given the price target . non-price qualifications are fulfilled given the price target . The joint work even commences before actual production. The joint work even commences before actual production.

production. production.

Parts imports could occur in two circumstances; Parts imports could occur in two circumstances;

The first is parts imports are used in the later stage of The first is parts imports are used in the later stage of production. However, their output can be classified in production. However, their output can be classified in the same category under the standard industrial the same category under the standard industrial classification like 4-digit ISIC. classification like 4-digit ISIC.

For example, 7 out of the top 10 of P&C exports are on For example, 7 out of the top 10 of P&C exports are on the top-10 of P&C Imports calculated at the 5 digit the top-10 of P&C Imports calculated at the 5 digit SITC level of disaggregation, suggesting the high level SITC level of disaggregation, suggesting the high level of intra-product trade. of intra-product trade.

Hence, the disciplining effect is still observed. Hence, the disciplining effect is still observed.

The second is the imports are used by specific The second is the imports are used by specific customers which are in the different industry. Such customers which are in the different industry. Such parts are tailored to specific uses in the later production parts are tailored to specific uses in the later production stage and are not necessarily substitutes to products stage and are not necessarily substitutes to products which are classified in the same category. which are classified in the same category.

Even though the second is hard to refute its possibility, Even though the second is hard to refute its possibility, it is less likely due to the lucrative sale volumes from it is less likely due to the lucrative sale volumes from the production network. This would encourage the production network. This would encourage domestic enterprises enter and results in an increase in domestic enterprises enter and results in an increase in competition.competition.

Measure the extent to which the industry Measure the extent to which the industry participates in the production networkparticipates in the production network

The ratio of parts to total goods import values, is used to The ratio of parts to total goods import values, is used to measure the extent to which the imports are driven by the measure the extent to which the imports are driven by the network trade. network trade.

We use the list of parts which is a result of a careful We use the list of parts which is a result of a careful disaggregation of trade data based on the Revision 3 of disaggregation of trade data based on the Revision 3 of the Standard International Trade Classification (SITC, the Standard International Trade Classification (SITC, Rev 3) extracted from the United Nations trade data Rev 3) extracted from the United Nations trade data reporting system (UN Comtrade database) firstly reporting system (UN Comtrade database) firstly developed in Athukorala (2003) and further extended developed in Athukorala (2003) and further extended (adding lists of parts found in the firm interview) in (adding lists of parts found in the firm interview) in Athukorala & Kohpaiboon (2009)Athukorala & Kohpaiboon (2009)

The ModelThe Model

1 2ij

jj

PCMPC

IMP

Data Cleaning and Variable MeasuresData Cleaning and Variable Measures

Data for the study are compiled from unpublished Data for the study are compiled from unpublished returns to the Industrial Census 2006, the latest returns to the Industrial Census 2006, the latest industrial census available, conducted by the National industrial census available, conducted by the National Statistics Office (NSO). Statistics Office (NSO).

After cleaning criteria are applied, the remained After cleaning criteria are applied, the remained samples are 24,696, accounting for 75% of the samples are 24,696, accounting for 75% of the Thailand’s manufacturing gross output and 62% of Thailand’s manufacturing gross output and 62% of manufacturing value added in 2006.manufacturing value added in 2006.

The census was cleaned up by The census was cleaned up by checking duplicated samples.checking duplicated samples. delete establishments which had not responded to delete establishments which had not responded to

one or more the key questions such as sale value, one or more the key questions such as sale value, output and which had provided seemingly output and which had provided seemingly unrealistic information such as negative output unrealistic information such as negative output value.value.

Delete micro-enterprises defined as the plants with Delete micro-enterprises defined as the plants with less than 10 workers.less than 10 workers.

7 industries that are either to serve niches in the 7 industries that are either to serve niches in the domestic market (e.g. processing of nuclear fuel, domestic market (e.g. processing of nuclear fuel, manufacture of weapons and ammunition)manufacture of weapons and ammunition)

Econometric ProcedureEconometric Procedure OLS regression while paying attention on possible OLS regression while paying attention on possible

effect of outliers and problems emerged from clustered effect of outliers and problems emerged from clustered data.data.

Several robustness tests were undertaken. Several robustness tests were undertaken. Price-cost margin (A ratio of output/value added) Price-cost margin (A ratio of output/value added) How to measure import penetration (Denominator: including How to measure import penetration (Denominator: including

or excluding X)or excluding X) How to measure the plant’s foreign ownershipHow to measure the plant’s foreign ownership Econometric procedure (Quantile vs. OLS regression; 2SLS Econometric procedure (Quantile vs. OLS regression; 2SLS

and 3 SLS for Simultaneity problems)and 3 SLS for Simultaneity problems)

Result: OLS without outliers Result: OLS without outliers (Equation 6.3) (Equation 6.3)

( 27.2)*** 35.9 *** 47.6 *** 11.9 ***

7.4 *** 5.1 ***

2.5 *** 3.5 ***

. 0.72 0.04 0.05 0.05

0.06 0.001

+ 0.04 0.11 *

j ij ijij

ij ij

j j j

KPCM size mkt

L

developed otherfor

IMP PC IMP

5.1 *** 2.3 ***

1.8 * 6.9 *** 7.6 ***

2

0.007 0.001 *

0.0003 0.13 0.23

0.306;# 23,044; 432.25( 0.00)

j j j

j j

EOS XOR EOS

FOR CR OG

AdjR obs F stat p

Discussion on the effect of imports on Discussion on the effect of imports on pricesprices

In all specifications and robustness checks (Tables 6 and In all specifications and robustness checks (Tables 6 and 7), our finding supports the formulated hypothesis.7), our finding supports the formulated hypothesis.

For the final goods imports (i.e. ), there is a positive For the final goods imports (i.e. ), there is a positive relation between relation between PCMVPCMV and and IMPIMP. .

When imports surge, domestic firms tend to cut their When imports surge, domestic firms tend to cut their output to avoid direct competition with the import goods. output to avoid direct competition with the import goods.

Note that avoiding direct competition could be done by Note that avoiding direct competition could be done by producing different goods serving for certain niche in producing different goods serving for certain niche in the local market. Fabric and machinery are the the local market. Fabric and machinery are the example. example.

All other things being equal, the disciplining effect of All other things being equal, the disciplining effect of import would be negligible and the positive import would be negligible and the positive relationship perhaps reflects extra profit in the relationship perhaps reflects extra profit in the relatively less competitive environment there.relatively less competitive environment there.

By contrast, there is the net disciplining effect of By contrast, there is the net disciplining effect of import in the production network.import in the production network.

In the production network, firms work together long In the production network, firms work together long before mass production actually take place to ensure that before mass production actually take place to ensure that they reach price target as well as satisfy with non-price they reach price target as well as satisfy with non-price qualification.qualification.

Since the lead firm in the network usually multinational Since the lead firm in the network usually multinational enterprises utilizes their global network in setting price, enterprises utilizes their global network in setting price, price setting is approaching to the perfectly competitive price setting is approaching to the perfectly competitive market environment, reinforcing the disciplining effect market environment, reinforcing the disciplining effect of imports.of imports.

Conclusion and Policy InferencesConclusion and Policy Inferences

Our finding that the stronger disciplining effect is found in Our finding that the stronger disciplining effect is found in the production network highlights benefit of participating in the production network highlights benefit of participating in the production network in terms of efficient use of resources.the production network in terms of efficient use of resources.

It would be difficult for indigenous firms to participate and It would be difficult for indigenous firms to participate and enjoy the lucrative sale volume in the network in presence of enjoy the lucrative sale volume in the network in presence of cascading tariff structure and extensively use of tariff cascading tariff structure and extensively use of tariff exemption.exemption.

Rationalizing tariff structure and neutralizing economic Rationalizing tariff structure and neutralizing economic incentives are needed.incentives are needed.