Are Price Adjustments in Spatially Separated Markets Non Linear and/or Asymmetric?

Evidence from Non Parametric Tests on the EU Pork and Poultry Markets 1. Introduction The analysis of spatial price relationships has been long used in economics to assess the degree of integration of geographically separated markets. For well-functioning (integrated) markets spatial arbitrage activities will ensure that price shocks occurring in one market will elicit responses in other markets; in equilibrium, the price of a homogeneous good in separated locations will be, at most, equal to transportation costs (weak version of the LOP). However, when localized markets are not well integrated, profitability opportunities will not be fully exploited resulting, thus, into efficiency losses (e.g. Ardeni, 1989; Goodwin and Schroeder, 1991; Asche et al., 1999; Ghosh, 2003). Recently, research on price transmission between spatially separated food markets has focused on potential non linearities and asymmetries. Non linear price adjustments have been associated with the presence of transaction costs (e.g. transportation and freight costs, spoilage, and risk premium). Such costs may create a band of inactivity (neutral band) of price differentials within which spatial arbitrage activities are not profitable. Asymmetries of price transmission are present when the speed of response depends on whether shocks are positive or negative. The majority of empirical studies on non linearities and asymmetries of price adjustments in food markets has employed parametric models like the Threshold Autoregressive (TAR) and the Threshold Vector Error Correction Model (TVECM) (e.g.Goodwin and Grennes, 1998; Goodwin and Piggot, 2001; Balcome et al., 2007). Serra et al. (2006a) and Serra et al. (2006b), however, argued that the parametric models may turn out to be overly restrictive or unrealistic for two reasons: first, they require assumptions about the true nature of price adjustments, and second, they rely on constant over time inactivity

(transaction costs) bands. The non parametric (smoothing) regression techniques, in contrast, allow the data to determine the shape of the relationship of interest and they dispense with the assumption of stationary thresholds. Hence, they are more suitable for investigating non linearities and asymmetries of spatial price adjustments. Serra et al. (2006a) applied non parametric techniques in their study of spatial price relationships in four European pork markets (Spain, Germany, Denmark, and France). Serra et al. (2006b) also used non parametric techniques in their study of spatial price relationships in four US egg markets (Baltimore, Boston, Dubuque, and New York). The authors of those earlier works argued that the non parametric analysis provided evidence that deviations from long-run equilibrium tend to be arbitraged in a non linear and a non symmetric fashion. The arguments by Serra et al. (2006a) and Serra et al. (2006b), however, were based exclusively on the visual inspection of the non parametric fits. For the four European pork markets the non parametric fits had indeed non linear portions which, nevertheless, in all cases were located at the very extremes of the respective distributions of price differentials; at the interior, price adjustments appeared to be linear and symmetric. The non parametric (smoothing) techniques are certainly less restrictive compared to the parametric ones. However, near the boundary of the observation interval fewer observations are averaged and the kernel weights become asymmetric. As a result, the accuracy of any smoothing technique at the extreme parts of the distribution diminishes, and the bias and the variance of the estimates can be affected (Hrdle, 1989). One, therefore, has to wonder whether the non linearities and asymmetries reported by Serra et al. (2006a) is a genuine feature of the price transmissions or just an artifact of the boundary effect. To shed some light on this issue the present paper employs a non parametric specification test proposed by Horowitz and Hrdle (1994). Under the null, price adjustments are linear (and symmetric) while under the alternative they are given by an unknown smooth

function (allowing, thus, for transaction cost frictions which may result into non linearities and asymmetries). Serra et al. (2006a) emphasized the need for replication of their findings through methodological improvements and extensions to other markets and meat products. This study considers fourteen EU markets and two meats (pork and poultry). Moreover, it relies on longer time series (for the majority of markets weekly data for the period 1991 to 2006 are available, while the earlier study relied on data for the period 1994 to 2004). In what follows section 2 presents the analytical framework, section 3 the data and the empirical results, while section 4 offers conclusions.

2. Analytical Framework Let pit and

p jt

be the prices in markets i and j at time t . As in Serra et al. (2006a)

and Serra et al. (2006b) we assume that the adjustment in the price differential in t ,
Yt = ( pit p jt ) ( pit 1 p jt 1) , X t 1 = ( pit 1 p jt 1).

depends solely on the price differential in

t 1 ,

Therefore, with linearity and symmetry, adjustments can be

represented with a simple autoregressive model of price differentials

Yt = X t 1 + et (1 , )

where < 0 is the speed-of-adjustment parameter and et is a stationary and zero-mean error term. Given that (1) can be restrictive or unrealistic one may consider the following relationship between price adjustments and lagged price differentials
Yt = m X t 1) + t ( (2) ,

where m is an unknown smooth function and t is a stationary and zero-mean error. The regression function of (2) (that is, the conditional expectation of Yt given X t 1 ) can be estimated by an appropriate non parametric (smoothing) technique. For the problem at hand one wishes to test the hypotheses:

H 0 : E(Yt / X t 1) = X t 1 H1 : E(Yt / X t 1) = m( X t 1)

(3) ,

where under the null price adjustments are linear and symmetric and under the alternative they are non linear and asymmetric. Horowitz and Hrdle (1994) developed the non parametric HH test to select between a parametric Single Index Model (SIM) (probit or logit) and a semiparametric one. That test can be also used to assess whether the functional of interest is linear or non linear.1 The HH test statistic is computed as
HH = h w( X t1)(Yt Y )(Y
t=2
where Y P and Y NP

NP

Y )

(4) ,

are the parametric and the non parametric estimate, respectively, of the
NP

regression function; h is the bandwidth parameter used for estimating Y

, T is the number of

observations, and w is function which trims 5 percent of the extreme values of the conditioning variable to improve the tests power. In (4), the first difference term measures the deviation of the parametric fit from the true realizations, while the second difference term measures the distance between the regression values obtained under the null and the alternative. The residuals of the parametric fit are blown up by large differences between the parametric and the non parametric fit. Therefore, for the null hypothesis to be true, the residuals of the parametric must be small enough to accommodate large differences in the two alternative fits (Hrdle et al., 1999). The HH test statistic is distributed asymptotically as N ( 0,1) . The test is one-sided as the statistic diverges to

+ under the alternative

hypothesis against which it is consistent. The non parametric regression function has been estimated here using the Nadaraya-Watson estimator, defined as

Delgado and Miles (1997) applied the HH test to verify whether the demand for food in Spain is consistent with PIGLOG preferences (linearity of budget shares in the logarithm of income).

NP

X t1 x )Yt h t= 2 (x) = m x) = T ( X 1x K ( th ) t= 2

K(

(5) ,

where K is an appropriate kernel smoother (Hrdle, 1989).

3. Data and Empirical Results The data for the present study have been obtained from the European Commission. For 10 out of the 14 countries considered, prices are available from the first week of 1991 to the last week of 2006. Exceptions are Austria, Finland, and Sweden for which the earliest observations go back to the first week of 1995 and Portugal (only for poultry) where the earliest observation goes back to the first week of 1993. For both pork and poultry Germany has been selected as the benchmark country because it is a central EU market and, thus, it is expected to lead the price formation process.2 All non parametric estimations have been carried out using the Quartic Kernel, while the bandwidth parameters have been selected using cross-validation (Hrdle, 1989). 3.1 Price Transmission in the Pork Markets Prior to the parametric and the non parametric estimation of the regression fits all price differentials (e.g. pit 1 pGEt 1 , i = 1, 2,...,13 ) have been subjected to ADF tests for unit roots in order to avoid potential spurious regressions. Table 1 presents the ADF test results. In all cases, the null of unit root is strongly rejected by the data. Figures A.1 to A.13 in the Appendix present the parametric and the non parametric regression fits. 3 For all countries but the Netherlands the non linear portions of the non parametric fits are generally located at the very lower end of the respective price differential distributions in t 1 . Also, for most cases,
2

The same benchmark has been used by Serra et al. (2006a), as well. Note that direct trade between two markets is not necessary for transmission of price shocks. The reason is that the two markets can be integrated though third markets (e.g. two exporters that do not trade with each other but export to the same country) (Barrett and Li, 2002). 3 The dashed lines represent the parametric and solid lines the non parametric fits.

the parametric fits are almost indistinguishable from the non parametric ones over the parts of the distributions where the overwhelming majority of observations lie. Table 2 presents the HH test results. The null hypothesis (linearity and symmetry of price adjustments) is rejected at the 5 percent level only for the Netherlands. For countries where the null cannot be rejected, the parametric approach yields more efficient estimates than the non parametric one. Here, the parameter of interest is the speed-of -adjustment. Table 3 presents the parametric estimates of along with the respective t-statistics. The estimates have the theoretically expected sign (high price differential in t 1 works towards a reduction in the price differential during the next period) and they are statistically significant at any reasonable level. They are, however, generally quite low. Indeed, the highest-speed-of adjustment coefficient is 0.23 (Austria) and the lowest 0.017 (Greece) suggesting that the drive to equilibrium price differentials may take considerable amount of time. It is remarkable, that even for Denmark which has a common border and intense trade of with Germany the speed-of-adjustment coefficient is only 0.026. For the Netherlands, price differentials in the range 20 to 40 appear to be corrected faster than those in the range 0 to 20; also, the behavior of the non parametric fit is quite erratic for price differentials 40 and lower suggesting even perverse (positive) responses for a range of values around 50. 3.2 Price Transmission in the Poultry Markets As in the case of pork, the price differentials for poultry has been subjected to ADF for unit roots. Table 4 presents the ADF test results. For six countries (Austria, Finland, Ireland, the Netherlands, Sweden, and the UK) the null of unit root cannot be rejected at the 5 percent level. Given the presence unit roots in almost half of the series there were two options available: either not to pursue estimation of parametric and non parametric regressions for the above mentioned countries or to search among them for other benchmarks hoping to obtain additional stationary price differentials. Given that the objective has been to consider as many

models of price differentials as possible we took the second option (which is admittedly ad hoc). The ADF tests suggested that the price differentials between Sweden and the UK, Sweden and Finland, and the Netherlands and Austria do not contain units. 4 Therefore, the HH-test has been performed for 10 price differentials in total (for Belgium, Denmark, Spain, Greece, France, Italy, and Portugal, with Germany as benchmark; for Finland and the UK with Sweden as benchmark; and for Austria with Netherlands as benchmark). Figures B.1 to B.10 in the Appendix present the parametric and the non parametric regression fits, while Table 5 presents the HH test results. The null hypothesis (linearity and symmetry of price adjustments) is rejected at the 5 percent level only for the Spain (with Germany as benchmark) and for Finland (with Sweden as benchmark). Again, for countries where the null cannot be rejected, the parametric approach yields more efficient estimates than the non parametric one. Table 6 presents the parametric estimates of along with the respective t-statistics. The estimates have the theoretically expected sign but they are generally quite low. Indeed, the highest speed-of-adjustment coefficient is 0.14 (Portugal) and the lowest 0.005 (Greece). It is remarkable that for Denmark, Belgium, and France, which have common borders with Germany, the speed-of-adjustment coefficients are well below 0.10. For Spain, price differentials below 30 appear to be corrected faster than those above 15; for price differentials, however, between 30 and 15 (where the bulk of observations lie) the parametric and the non parametric fit almost coincide. For Finland, differences between the two fits exist both at the upper as well as at the lower part of the distribution of price differentials in t 1 .

4. Conclusions
4

The ADF test statistics (with constant and linear trend) for the price differentials between Sweden and Finland are 4.177 and 4.238, respectively, while for the price differential between the Netherlands and Austria is 3.628.

The objective of this paper has been to assess price transmissions in spatially separated pork and poultry markets in the EU, with emphasis on non linearities and/or asymmetries. This has been pursued using non parametric regression techniques along with a specification test for the parametric AR(1) model of price adjustments. The parametric AR(1) model has been rejected in favor of a non-linear and/or asymmetric smooth model of transmissions in only 3 (1 for pork and 2 for poultry) out of the 23 cases considered. The test results have been generally in line with the visual comparison of the respective parametric and non parametric fits; the non-linear portions of the latter have been almost invariably located at the very extremes of the price differential distributions, while quite often the two competing fits have been indistinguishable from each other over the parts of the distributions where the majority of observations lie. The idea of the presence of an inactivity (transaction costs) band within which price differentials behave like a random walk process is intuitively appealing. But when a price differential lies in that band, the markets are in competitive spatial equilibrium. As noted by Barrett and Li (2002) the notion of competitive spatial equilibrium is a different (although related) notion to that of market integration, where the latter is defined as tradability and transmission of price shocks between markets. In the light of the arguments by Barrett and Li (2002), the failure of the HH test to reject the null should not be necessarily interpreted as evidence against the existence of inactivity bands. The reason is that it may simply indicate that, over the period considered, the EU pork and poultry markets only rarely attained competitive spatial equilibrium. In such case, possible inactivity bands will not be easily captured by statistical designs because of the lack of an adequate number of observations within those bands. As far as the market integration is concerned, price transmission appears to take place but in most cases the speed-of-adjustment is quite low. The latter certainly raises questions about how well integrated are the pork and the poultry markets in the EU.

The present work may be extended in a number of directions. First, future works may consider price transmissions in other food commodities; second, they may apply alternative non parametric tests and compare their results; third, they may consider different specifications of the parametric null (e.g. AR(p) models instead of AR(1)).

References Ardeni., P. (1989). Does the Law of One Price Really Hold for Commodity Prices? American Journal of Agricultural Economics, 71:661-669. Asche, F., Bremnes, H., and C. Wessels (1999). Product Aggregation, Market Integration and Relationships Between Prices. American Journal of Agricultural Economics, 81:56881. Balcome, K., Bailey, A., and J. Brooks (2007). Threshold Effects in Price Transmission. American Journal of Agricultural Economics, 89:308-323. Barrett, C., and J.R. Li (2002). Distinguishing Between Equilibrium and Integration in Spatial Price Analysis. American Journal of Agricultural Economics, 84:292-307. Delgado, M., and D. Miles (1997). Household Characteristics and Consumption Behavior: A Non Parametric Approach. Empirical Economics, 22:409-429. Ghosh, M. (2003). Spatial Integration of Wheat Markets in India: Evidence from Cointegration Tests. Oxford Development Studies, 31:159-71. Goodwin, B., and T. Schroeder (1991). Cointegration Tests and Spatial market linkages in Regional Cattle Markets. American Journal of Agricultural Economics, 73:452-464. Goodwin, B., and T. Grennes (1998). Tsarist Russia and the World Wheat Market. Explorations in Economic History, 39:154-182. Goodwin, B., and N. Piggot (2001). Spatial Market Integration in the Presence of Threshold Effects. American Journal of Agricultural Economics, 83:302-317. Hrdle, W. (1989). Applied Non Parametric Regression. Cambridge University Press. Hrdle, W., Muller, M., Sperlich, S., and A. Werwatz (1999). Non and Semiparametric Modeling. Berlin: Humboldt-Universitt du Belrin. Horrowitz, J., and W. Hrdle (1994). Testing a Parametric Model Against a Semiparametric Alternative. Econometric Theory, 10:821-848. Serra, T., Gil, J., and B. Goodwin (2006a). Local Polynomial Fitting and Spatial Price Relationships: Price Transmission in EU Pork Markets. European Review of Agricultural Economics, 33: 415-36. Serra, T., Gil, J., and B. Goodwin (2006b). Non Parametric Modeling of Spatial Price Relationships. Journal of Agricultural Economics, 57:501-22.

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Table 1. ADF Test Results on Pork Price Differentials* Country Empirical Value Country Empirical Value of the Test of the Test Statistic Statistic Austria -8.238 Ireland -6.225 Belgium -5.452 Italy -4.845 Denmark -7.059 Netherlands -7.122 Spain -7.7 Portugal -6.447 Greece -5.676 Sweden -4.416 Finland -4.122 United Kingdom -6.205 France -8.581
* The ADF regression includes constant and linear trend; the lags have been selected optimally using the Schwartz criterion; the 5 percent critical value is -3.145.

Table 2. HH Test Results on Pork Price Differentials* Country Austria Belgium Denmark Spain Greece Finland France Empirical Value of the Test Statistic -0.26 0.43 1.03 0.23 -0.92 0.03 1.61 Country Empirical Value of the Test Statistic Ireland 0.7 Italy 0.02 Netherlands 3.19 Portugal 0.16 Sweden 0.003 United Kingdom -0.13

* The 5 percent critical value is 1.65.

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Table 3. Speed-of-Adjustment Parameter Estimates for Pork* Country Austria Belgium Denmark Spain Greece Finland France Estimate -0.232 (-9.04) -0.037 (-4.05) -0.026 (-3.29) -0.128 (-7.57) -0.017 (-2.59) -0.021 (-2.55) -0.082 (-5.91) Country Ireland Italy Netherlands Portugal Sweden United Kingdom Estimate -0.027 (-3.38) -0.021 (-3.06) N.A -0.058 (-5.01) -0.03 (-3.08) -0.034 (-3.73)

* N.A: Non Applicable; t-statistics in parentheses. The 5 percent critical value is 1.65 (one-sided test).

Table 4. ADF Test Results on Poultry Price Differentials* Country Austria Belgium Denmark Spain Greece Finland France Empirical Value of the Test Statistic -2.337 -7.188 -3.492 -8.203 -3.421 -2.084 -4.194 Country Empirical Value of the Test Statistic Ireland -1.079 Italy -6.782 Netherlands -3.122 Portugal -7.804 Sweden -1.585 United Kingdom -1.438

* The ADF regression includes constant and linear trend; the lags have been selected optimally using the Schwartz criterion; the 5 percent critical value is -3.145; benchmark country is Germany.

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Table 5. HH Test Results on Poultry Price Differentials* Country Austria**** Belgium** Denmark** Spain** Greece** Empirical Value of the Test Statistic 1.51 -0.12 1.27 2.30 0.02 Country Finland*** France** Italy** Portugal** United Kingdom*** Empirical Value of the Test Statistic 5.5 0.42 0.18 0.96 1.48

* The 5 percent critical value is 1.65; ** benchmark country is Germany; *** benchmark country is Sweden; **** benchmark country is the Netherlands.

Table 6. Speed-of-Adjustment Parameter Estimates for Poultry* Country Austria**** Belgium** Denmark** Spain** Greece** Estimate -0.011 (1.93) -0.057 (-4.82) -0.072 (-5.40) N.A. -0.005 (-1.70) Country Finland *** France** Italy** Portugal** United Kingdom*** Estimate N.A. -0.022 (-3.20) -0.038 (-4.02) -0.138 (-7.36) -0.026 (-2.91)

* N.A: Non Apppicable; t-statistics in parentheses. The 5 percent critical value is 1.65 (one-sided test); ** benchmark country is Germany; *** benchmark country is Sweden; **** benchmark country is the Netherlands.

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APPENDIX: Graphs of Parametric and Non Parametric Fits

Figure A.1. Pork: Austria-Germany

Figure A.2. Pork: Belgium-Germany.

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Figure A.3. Pork: Denmark-Germany.

Figure A.4. Pork: Spain-Germany.

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Figure A.5. Pork: Greece-Germany.

Figure A.6. Pork: Finland-Germany.

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Figure A.7. Pork: France-Germany.

Figure A.8. Pork: Ireland-Germany.

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Figure A.9. Pork: Italy-Germany.

Figure A.10. Pork: Netherlands-Germany.

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Figure A.11. Pork: Portugal-Germany.

Figure A.12. Pork: Sweden-Germany.

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Figure A.13. Pork: United Kingdom-Germany.

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Figure B.1. Poultry: Austria-Netherlands.

Figure B.2. Poultry: Belgium-Germany.

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Figure B.3. Poultry: Denmark-Germany.

Figure B.4. Poultry markets: Spain-Germany.

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Figure B.5. Poultry markets: Greece-Germany.

Figure B.6. Poultry: Finland-Sweden.

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Figure B.7. Poultry: France-Germany.

Figure B.8. Poultry: Italy-Germany.

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Figure B.9. Poultry: Portugal-Germany.

Figure B.10. Poultry: United Kingdom-Sweden.

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