RDP 9707: Internationalisation and Pricing Behaviour: Some Evidence for Australia 2. Trends in Openness and Previous Work on the Relationship between Openness and Price Setting

The Australian economy is clearly more outwardly oriented today than it was a decade or two ago. Import and export shares have both risen steadily, particularly in the manufacturing sector, as have inward and outward levels of foreign investment. The ratio of imports of manufactures to domestic sales was 35 per cent in 1994/95, up from 17 per cent in 1968/69. The proportion of output of domestic manufacturing firms which is exported has risen similarly. In 1968/69, around 9 per cent of domestic manufacturing production was exported; by 1994/95 this ratio had risen to 25 per cent.^[2]

This increase in openness has not simply been driven by changes in the trade share of a few large manufacturing industries. Rather, there appears to have been a general move toward openness across the manufacturing sector. Between the late 1960s and the early 1990s, the ratio of imports to domestic sales increased in 27 of the 30 manufacturing industries considered in this study. The corresponding export ratio rose in 26 of the industries over the same period. As a result, the proportion of manufacturing industries which can be classified as import competing increased from 77 per cent to 97 per cent, and the proportion that can be classified as exportable rose from 7 per cent to 30 per cent.^[3]

A number of factors have contributed to this increase in openness. First among these is that domestic protection levels have been substantially reduced. The average effective rate of assistance afforded domestic manufacturing industries fell from 36 per cent in 1968/69 to around 12 per cent in 1992/93.^[4] This change in policy has exposed domestic industry to increased foreign competition, and has encouraged resources to move towards industries in which Australia has a comparative advantage. Other government reforms, including a range of microeconomic reforms, which have been partially justified on the grounds that they will improve Australia's international competitiveness, have also encouraged industries to adopt a more outward orientation. A third factor which has driven the economy to be more outwardly oriented is growth itself. As wealth accumulates in the economy there is typically an increase in the demand for variety. This naturally leads to an increase in intra-industry trade and hence, an increasingly outwardly oriented economy.

In theoretical terms, the link between openness and price-setting behaviour follows from the presumption that having a more open economy should lead to an improvement in the efficiency with which domestic goods are produced and priced. Helpman and Krugman (1989) argue that this is one of the basic implications of international trade theory under imperfect competition. Increasing trade exposure, by raising the level of competition, should reduce the ability of domestic producers and domestic factors of production to extract rents. Thus as an economy opens up, domestic prices of tradeable goods should move toward the level implied by the law of one price, and across the business cycle, these prices should move increasingly closely with the prices of their internationally produced substitutes.

There has been relatively little work in Australia examining the implications for inflation of internationalisation. In recent work, Bloch (1996) and the Bureau of Industry Economics (1989), examine changes in the international competitiveness of the domestic manufacturing industry at varying levels of disaggregation. They find widely differing results across industries, but do not relate these to the openness of the various industries.

More recently, Dwyer and Romalis (1996) broadly followed the approach adopted by Hall (1988) to identify the mark-up of price over marginal cost for manufacturing industries, and attempted to identify the specific effect that internationalisation has had on this mark-up. They find that internationalisation has significantly eroded these mark-ups, especially in imperfectly competitive industries; however, the aggregate effect on prices is fairly small in magnitude. Dwyer and Romalis acknowledge that their approach very likely understates the role played by increasing trade exposure, as it does not capture any impacts of increased trade exposure on costs and productivity growth.^[5]

Footnotes

Industry Commission (1995) and Clark, Geer and Underhill (1996). [2]

Following Dwyer (1990,1992), industries are classified as import competing if the ratio of imports to domestic production is greater than 10 per cent, and are classified as exportable if the ratio of exports to domestic production is greater than 10 per cent. The manufacturing sector is divided into 30 IOCC industry groupings for this analysis. Industry groupings are shown in Appendix C, Table C2, along with the concordance between ASIC and IOCC groups. Data source: Industry Commission (1995). [3]

Industry Commission (1995), p. A1.1. [4]

Inherent difficulties in accurately measuring marginal cost can also imply that the estimated relationship between the mark-up and trade exposure, although statistically significant, is weak. Much the same problem has been identified in the industrial organisation literature where the evidence for a relationship between concentration and prices is much stronger than between concentration and profitability (Schmalensee 1989, p. 989). [5]