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A price transmission testing framework

As mentioned in section 2, the extent of price transmission lacks a direct unambiguous empirical counterpart in the form of single formal testing. The definition of price transmission provided in the section above encompasses the case of perfect market integration, the inherent dynamic market relationships that arise due to inertia or discontinuities in trade, as well as non linearities that may arise due to policies and other distortions in arbitrage. More importantly, it implies hypotheses, through its components, that are testable within a cointegration-error correction model framework. A number of time series techniques can be used to test each of the components of price transmission and thus ultimately assess the extent of price transmission. These are as follows:

cointegration; causality; error correction mechanism; and, symmetry.

Each of the above tests are taken to present evidence about the components of transmission thus providing particular insights into its nature. Collectively, these techniques offer a framework for the assessment of price transmission and market integration.

The concept of cointegration (Granger, 1981) and the methods for estimating a cointegrated relation or system (inter alia Engle and Granger, 1987; Johansen, 1988, 1991, 1995) provide a framework for estimating and testing for long run equilibrium relationships between non stationary integrated variables.[49] Cointegration has been extensively discussed and applied in

the literature and thus a detailed examination is beyond the scope of this paper (Maddala and Kim, 1998 provide a thorough and extensive review of cointegration). However, a brief description of the concept and the estimation methods in the context of the present analysis is provided. If two prices in spatially separated markets (or different levels of the supply chain) p1t and p2t contain stochastic trends and are integrated of the same order, say I(d), the prices are said to be cointegrated if: p1t - b p2t = ut (3)

is I(0). b is referred to as the cointegrating vector (in the case of two variables a scalar), whilst equation (3) is said to be the cointegrating regression. The above relationship can be estimated utilizing inter alia Ordinary Least Squares OLS (Engle and Granger, 1987), or a Full Information Maximum Likelihood method developed by Johansen (1988, 1991) that is most commonly encountered in the literature. More specifically, p1t and p2t are cointegrated, if there is a linear combination between them that does not have a stochastic trend even though the individual series contain stochastic trends (see Stock and Watson, 1988, for the stochastic trend representation of cointegrated systems). Cointegration implies that these prices move closely together in the long run, although in the short run they may drift apart, and thus is consistent with the concept of market integration. Engle and Granger test the null of no cointegration by applying unit root tests on . Johansen derived the distribution of two test statistics for the null of no cointegration

referred to as the Trace and the Eigenvalue tests.[50]

As ut is stationary, the prices contain stochastic trends that have a long-run proportionality, with the cointegrating parameter b measuring the long-run equilibrium relationship between them. This parameter has sometimes been interpreted as the "elasticity of price transmission", when the price series are converted into logarithms. However, this cointegrating parameter does not identify this elasticity, or in other words, the completeness of transmission, particularly well, as recognized by Balcombe and Morrison (2002) and Barrett and Li (2002). Cointegration is a statistical concept and thus "atheoretical", whilst the cointegrating parameter may not have any economic interpretation, in the way a parameter of a structural model has. For example, if prices in spatially separated markets have a common stochastic trend reflecting inflation, the cointegrating parameter will be equal to one mirroring a proportionality of unity and implying that price transmission is complete.

Nevertheless, failure to reject the null of non cointegration implies that the two prices drift apart in the long run, as they are driven by stochastic trends that are not proportional. In this case, some changes in one price, say the international market price, may to a certain extent be transmitted to the domestic market price, however, other factors, such as policies or deviations from marginal cost pricing determine the movements of the domestic market price, thus resulting in absence of market integration. A potential shortcoming of cointegration in testing for market integration is the implicit assumption that transfer costs are stationary (Fackler and Goodwin, 2001; Barret and Li, 2002). Non stationary transfer costs will result in cointegration tests suggesting the absence of market integration, as the international and domestic prices drift apart, in spite of the fact that price signals are transmitted from one market to another. Nevertheless, non stationary transfer costs cause domestic prices to move independently from international prices, thus limiting the information that is available to producers.