MODEL CLOSURE AND PRICE FORMATION: CONCEPTS AND APPLICATIONS

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BACKGROUND

Over the past decade economic literature has studied the transmission of prices between spatial markets and analysed the extent to which markets are integrated. According to the basic principles laid down by the theory of the law of one price when trade occurs between two markets, the markets are integrated and the difference in the prices equals the transaction costs to move the goods between those markets in the long run (Goodwin, Grennes and Wohlgenant, 1990). The equilibrium price in the smaller market can be estimated as a function of the equilibrium price in the dominant market, the exchange rate and the transaction costs. As soon as the difference in the market prices becomes less than the transaction costs, trade is discontinued and the markets are no longer integrated (Sexton, Kling and Carmen, 1991).
The market equilibrium (equilibrium price) is then a function of the domestic supply and demand factors in each market respectively. Thus, the formation of prices, also referred to as the equilibrium pricing condition (Barrett, 1999) in a specific market, changes as the market switches between different market regimes. According to Barret (1999), if a commodity moves from a non-tradable (importable) to an exportable (non-tradable) equilibrium, the correlation between the parity price and the local market prices should jump from (to) zero to (from) significantly positive, to (from) one if the law of one price holds strictly. From a modelling perspective, the technique that is used to “close” a simultaneous or recursive simulation model determines the manner in which market equilibrium is achieved in the model.
Many different model closure techniques exist. The choice of closure technique will depend on the equilibrium pricing condition in a specific market, specifically on which market regime prevails in the market. Models used in policy evaluation usually either ignore the possible existence of more than one market regime using just a single linear method of price determination based on average effects, or incorporate highly stylised components that may not reflect the complexities of a particular market. This implies that the estimated price transmission elasticity is likely to be moderate, understating the true elasticity when supplies are either large or small relative to domestic demand, but overstating the true response when domestic supply and demand are in balance.
Although these models may appear statistically sound, they could present a simplification of the price-formation process. Colman (1995) noted that the concept of an elasticity of price transmission needs to be treated carefully. In particular, equating perfect price transmission with an elasticity of one only makes sense if all duties and transport costs are proportional to price. Barrett and Li (2002) referred to the “messy character of market relationships” arising from treating price transmissions mostly as a linear phenomenon. Balcombe (2003) more recently raised the concern that parameters in transmission equations do not correspond to the structural parameters which they are thought to represent.
He also noted that theoretical models often contain either assumptions that are not met in practice, or identification conditions that cannot be established by examining the data alone. This comment is especially relevant in the Southern African markets where price relationships often indicate no opportunity for arbitrage and trade still occurs between the nations. This point will be discussed further in chapter 2. In South Africa only a handful of studies have addressed price transmission and price formation in the agricultural market, and even fewer studies have addressed these issues within a partial equilibrium framework.
Schimmelpfennig, Meyer, Beyers and Scheepers (2003) undertook one of the most recent studies on price transmission and presented an Error-Correction-Model (ECM) of the short- and long-run equilibrium between the world price of maize, the local producer and consumer price of maize, and the exchange rate. Although this study focused on long- and short-term shocks in the maize market, the switch of trade regimes1 , which determines the equilibrium pricing condition, was not taken into account and just a single method of price determination based on average effects was represented in the model. The study was also not undertaken within a partial equilibrium framework. Meyer and Kirsten (2005) presented the price-formation process in the wheat industry within a partial equilibrium framework, but did not address the possibility of a switch in market regimes.

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TABLE OF CONTENTS :

ACKNOWLEDGEMENTS
ABSTRACT
TABLE OF CONTENTS
LIST OF TABLES
LIST OF FIGURES
CHAPTER 1: INTRODUCTION
- 1.1 BACKGROUND
- 1.2 PROBLEM STATEMENT AND JUSTIFICATION OF RESEARCH
- 1.3 STATEMENT OF HYPOTHESIS
- 1.4 OBJECTIVES AND METHODOLOGY OF THE STUDY
- 1.5 OUTLINE OF STUDY
CHAPTER 2: MODEL CLOSURE AND PRICE FORMATION: CONCEPTS AND APPLICATIONS
- 2.1 INTRODUCTION
- 2.2 PRICE FORMATION AND MODEL CLOSURE: A REVIEW
- 2.2.1 BACKGROUND OF PRICE FORMATION
- 2.2.2 CONCEPTUALISING MODEL CLOSURE
- 2.3 AN OVERVIEW OF THE GRAIN MARKETS
- 2.3.1 THE DATABASE
- 2.3.2 IDENTIFYING THE ALTERNATIVE MARKET REGIMES
- 2.4 SUMMARYCHAPTER 3: THEORETICAL FOUNDATION OF PARTIAL EQUILIBRIUM MODELLING
- 3.1 INTRODUCTION
- 3.2 THE DOMESTIC DEMAND AND SUPPLY COMPONENTS OF THE
- EXISTING PARTIAL EQUILIBRIUM MODEL
- 3.2.1 DOMESTIC SUPPLY
- 3.2.1.1 PRODUCER SUPPLY
- 3.2.1.2 BEGINNING STOCKS
- 3.2.2 DOMESTIC DEMAND
- 3.2.2.1 CONSUMER DEMAND
- 3.2.2.2 FEED DEMAND
- 3.2.2.3 ENDING STOCKS/INVENTORY
- 3.3 MODEL CLOSURE AND PRICE FORMATION UNDER SWITCHING
- MARKET REGIMES
- 3.3.1 THE FLOW DIAGRAM AND THE PRICE QUANTITY (P-Q)
- DIAGRAM
- 3.3.2 THE TRADE AND PRICE LINKAGE COMPONENTS UNDER
- SWITCHING MARKET REGIMES
- 3.3.2.1 NEAR- AUTARKY
- 3.3.2.2 IMPORT AND EXPORT PARITY
- 3.4 ESTIMATION PROCEDURES, MODEL SOLVING AND
- VALIDATION
- 3.5 SUMMARY
CHAPTER 4: THE REGIME-SWITCHING MODEL
- 4.1 INTRODUCTION
- 4.2 EMPIRICAL RESULTS
- 4.2.1 DOMESTIC SUPPLY
- 4.2.2 DOMESTIC DEMAND
- 4.2.3 MODEL CLOSURE
- 4.3 THE REGIME-SWITCHING MECHANISM
- 4.4 SUMMARY
CHAPTER 5: BASELINE PROJECTIONS, IMPACT MULTIPLIERS
- AND SCENARIO ANALYSES
- 5.1 INTRODUCTION
- 5.2 THE BASELINE
- 5.3 IMPACT MULTIPLIERS
- 5.4 THE OLD VERSUS THE NEW MODEL
- 5.5 ELASTICITY MATRICES
- 5.6 SCENARIO ANALYSIS
- 5.7 SUMMARY
CHAPTER 6: CONCLUSION
- REFERENCES
- APPENDIX
- APPENDIX