Price-based studies

In comparison to the trade volumes literature, disaggregated price-based studies of the relationship between tariffs and product market integration are less prevalent. This is despite the benefits of using product price data rather than information on trade flows as the basis for measuring product market integration. As explained in Chapters 1 and 3, estimates of product market integration based on the volume of trade between countries may be misleading since variation in the level of trade flows can be consistent with a single trade cost and the same degree of product market integration.

Research on regional trade agreements and product market integration

One arm of the price-based literature examines the relationship between tariffs and market integration indirectly by using product price level data to compare border effects and relative prices for countries that share membership in a FTA or customs union with those between countries that do not belong to a particular regional trade grouping. In theory, trade or monetary agreements

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that reduce barriers to trade and arbitrage (by, for example, reducing tariffs or exchange rate volatility) are expected to allow the forces of arbitrage to eliminate price differentials for consumer goods across countries (Parsley & Wei, 2002).

The evidence on the impact of trade agreements on product market integration drawn from studies using actual price level data generally supports the theory.⁷⁰ Using a panel of prices for 95 traded goods across 83 cities in 69 different countries for the period from 1990 to 2000, Parsley and Wei (2002) find that price dispersion is significantly lower between countries that share membership in the EU, European Free Trade Association, NAFTA or MERCOSUR trade blocs. They conclude that trade blocs promote goods market integration more effectively than unilateral trade liberalization. Similarly, using annual price level data for 101 tradable goods across 108 cities in 70 countries from 1990 to 2005, Bergin and Glick (2007) observe that price dispersion declines when countries participate in a regional trade agreement.⁷¹

As Anderson and van Wincoop (2004: 722) note, however, while it is relatively well documented in the literature that FTAs and customs unions reduce trade barriers and even cross-border product price dispersion, “it is less clear what elements of these trade agreements play a role (tariffs, NTBs, or regulatory issues).” In this respect, the precise role played by tariffs in generating cross-border price dispersion is comparatively understudied.

Research on the pass-through effects of tariffs onto prices

Much of the existing literature that has looked directly at the role of tariffs is focused on the price transmission and welfare aspects of tariff liberalization. For instance, several studies have examined the pass-through effects of changes in tariffs on local, import or export prices using different methodologies (Nicita, 2009; Cherkaoui, 2011; De Loecker et al., 2012; Bas & Strauss-Kahn, 2013).

70 This is not, however, the case for all price-based studies. For instance, Engel and Rogers (1996) examine border effects between the United States and Canada using CPI data. They segment their data into sub-samples in order to separate the periods before and after the introduction of the United States-Canadian FTA, and find that the size of the border effect – reflected in the magnitude of the estimated border coefficient – was actually larger in the period after the FTA came into effect. Confronted with this seemingly counterintuitive finding, the authors raise the possibility that informal trade barriers may have contributed to the observed price dispersion.

71 Bergin and Glick (2007) also find that that cross-country price dispersion declines when countries participate in a currency union. This is backed by similar findings in Parsley and Wei (2002) and Foad (2004) for the EU, who also show that currency union arrangements facilitate deeper product market integration between participating countries.

In contrast, however, a number of studies find little evidence that the introduction of the euro has reduced price dispersion across EU member states (Lutz, 2000; Rogers, 2002; Engel & Rogers, 2004). Furthermore, looking at Africa, Parsley and Wei (2002) find that product markets within the CFA zone are “not very integrated”, despite the fact that the CFA countries share a common currency.

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A key focus in the tariff pass-through literature is on the extent to which movements in border prices arising from tariff changes between importing and exporting countries are passed-through to domestic prices or absorbed through changes in exporter mark-ups (Nicita, 2004). A number of studies find evidence of the pro-competitive effects of trade liberalization on domestic prices in developing countries (see, for instance, Cherkaoui (2011) for Morocco; De Loecker et al. (2012) for India; and Bas & Strauss-Kahn (2013) for China). De Loecker et al. (2012) show that not only do lower tariffs induce Indian firms to reduce their mark-ups through the pro-competitive effect, but they also reduce the marginal costs faced by these firms. However, the authors observe that firms take advantage of the lower marginal costs to raise their mark-ups, meaning that the cost advantage of the input tariff reductions is not fully passed on to consumers through lower prices.

Nicita (2009) measures the effect of tariff liberalization on domestic prices in Mexico. He shows that the liberalization of tariffs in Mexico following the commencement of NAFTA negotiations in the 1990s reduced domestic consumer prices for both agricultural and manufacturing products, but these effects were not uniform across Mexican states. Using regression analysis, the author examines the determinants of the market price of a particular good in a specific region. His explanatory variables include distance (the shortest driving distance between Mexican states) as a proxy for trade costs, a good-specific tariff variable, and an interaction between distance and the tariff variable for each good. The latter is included in order to isolate the marginal effect of tariff movements on the market price of a particular good in a specific region.

By doing so, Nicita (2009) examines both the change in domestic prices induced by a change in tariffs as well as the effect of trade costs on the pass-through of tariff changes to local prices. He reports a positive and significant coefficient on the tariff variable, suggesting that local prices increase with rising tariffs. He finds that the pass-through rate of tariffs onto local prices is higher for agricultural products (33 percent, on average, for the country as a whole) in comparison to their manufacturing (27 percent) counterparts.⁷² In addition, he shows that in the case of manufactured products, the pass-through rate is lower for regions located further from the United States border; with regions located closer to the border found to be more exposed to the effects of changes in manufacturing tariffs.⁷³ Importantly, Nicita (2009) only focuses on distance-related

72 Campa and Goldberg (2002) report larger pass-through rates for a range of developed economies.

73 Nicita (2009: 23) explains that: “Taking into account regional differences the tariff pass-through at the border is about 70% for manufacturing. The tariff pass-through declines to about 40% at 1000km and to about 20% at 2000km from the border.”

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trade costs within Mexico, and does not examine the interaction between tariffs and border-related trade costs or international trade costs more generally.

Parsley and Wei (2007) examine the impact of tariffs within the context of the role of traded goods prices in real exchange rate movements. Using price observations that match the prices of Big Macs to the prices of their individual ingredients for 34 countries spanning 13 years from 1990 to 2002, the authors employ a systematic panel regression approach to examine the relative importance of deviations in the international prices of traded goods in explaining real exchange rate movements. Interestingly, the authors find that tariffs – measured as the sum of mean tariff rates between country pairs – have a statistically significant impact in reducing the influence that deviations in traded goods prices have on real exchange rates. They attribute this to the reality that the presence of higher tariffs reduces the scope for arbitrage.

Bas and Strauss-Kahn (2013) focus on export prices and employ a difference-in-difference approach to exploit variation in recent changes in input tariffs between ‘ordinary’ trade regime firms and ‘processing trade regime firms in China – with the latter exempted from paying tariffs for at least 30 years. They show that reductions in Chinese tariffs on imported inputs between 2000 and 2006 – which followed China’s accession to the World Trade Organization (WTO) and benefited firms under the ordinary trade regime – actually led to these firms raising their export prices. According to the authors, this is because these firms were able to upgrade their inputs at lower cost following the tariff liberalization; which, in turn, enabled them to upgrade the quality of their exported products. In contrast, the firms that did not benefit from lower imported input costs via the tariff reduction (firms that fell under the processing trade regime) reduced their export prices. The authors attribute the latter to a pro-competitive effect arising from the loss of the cost advantage previously enjoyed by processing firms. Following the tariff reductions, the Chinese processing firms faced more stringent competition in export markets from their ordinary trade regime counterparts and, as a result, reduced their mark-ups.

Research on the relationship between tariffs and border effects

Very few price-based studies have looked directly at the potential role played by tariffs in generating border effects that raise cross-country product price dispersion. One notable exception is Bergin and Glick (2007). In their multi-country study, Bergin and Glick (2007) model price dispersion between cities as a function of a number of trade friction determinants, including

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distance, national borders, language differences, tariff barriers and exchange rate volatility. They find that price dispersion increases with tariffs. Importantly, however, the authors measure tariff barriers as the simple sum of the average tariff rates in both countries for cross-country city pairs.⁷⁴ As a result, they are not able to exploit variation in tariffs at the product level. Allowing tariffs to vary by product is likely to be important given that there is generally a high level of variation in tariffs across goods at the individual country level (Anderson & van Wincoop, 2004). Furthermore, the authors do not interrogate the marginal effect of tariffs on the border effect.

5.4.3 Price-based studies of the relationship between tariffs and product market