Import-as-Market-Discipline in Production Networks: Evidence of Thai Manufacturing Sector

1. Import-as-Market-Discipline in Production Networks: Evidence of Thai Manufacturing Sector ArchanunKohpaiboon Faculty of Economics, Thammasat University and and Juthathip Jongwanich, School of Management, Asian Institute of Technology

2. Issues How firms change their pricing behavior in response to threat from imports remains interesting to the international economics literature. Generally, imports can force firms to set price competitively and improve the efficient use of limited resources. The effect of import on price setting behavior is known as import as a market discipline hypothesis (Levinsohn,1993).

3. What makes the issue interesting is the mixed outcome in empirical studies. • Negative relationship • Esposito & Esposito (1971) • Pagoulatos & Sorensen (1976) • Pugel (1980) • Lyons (1981) • Geroski (1982) • Neuman et al. (1984) • Chou (1986) • De Ghellincket al. (1988); Levinsohn (1993) • Katies & Peterson (1994) • Positive relationship - Urata (1979); - Pagoulatos & Sorensen (1981) - Nolle (1991) - Ståhlhammer (1991, 1992) - Field & Pagoulatos (1994).

4. Interestingly, since 1990 global production network has gained its relative importance in global trade, reflecting by the rapid expansion of trade in parts and components (Athukorala, 2011). Intermediates like parts and components traded under the production network are far different from those traded in the arms’ length transaction. Sometimes, we cannot be noticed by its appearance (reflected by serial numbers), e.g. specific integrated circuits jointly developed between Celestica and Panasonic for Flat screen TVs (Kohpaiboon, 2011).

5. Examples From the most capital intensive activities like R&D, Product development and design to the most labor intensive activity like assembly Stage 5 Country D Stage 4 Country C Stage 3 Stage 2 Country B Stage 1 Country A

6. Example: Apple iPhone 3G

7. Y-O-Y Export Growth (%)

8. Given such difference, therefore, the effect of import on firms’ price setting behavior would be different between network and non-network trade. This issue is highly policy relevant for developing countries which are still reluctant to continue trade liberalization (e.g. selective approach and rely on tariff exemption/rebate schemes) as well as in a period of a rise of protectionism threat amidst the global economic recession. Evidence of gains from trade liberalization is still needed.

9. Paper Examine the import-as market discipline hypothesis in Thai manufacturing with a hypothesis of possible different effect of fragmentation-driven parts and final goods imports, using the latest available industrial census (2006) is used. Thai manufacturing has long experience participating in the production network. Thailand still has high nominal protection by the regional standards (Jongwanich & Kohpaiboon, 2007).

10. Analytical Framework The effect of import on price setting behavior (how different between price and marginal cost) is based on the fact that imports and domestically produced goods are close substitutes. The more the imports, the greater the pressure on price narrowing a gap between price and marginal costs. It is unlikely for firms to set price far above marginal costs (i.e. improve efficient use of resources). As argued in Lopez and Lopez (1996), the net effect depends on the oligopolistic response of firms to changes in imports

11. In some cases where domestic firms cut their output in response to import surges, the net effect on price would be less. Our core hypothesis in this paper is a possible different effect of fragmentation-driven parts imports as opposed to final good imports. The disciplining effect of import would be stronger in the network trade (the network import has stronger effect in narrowing the gap between price and marginal cost).

12. Given the fact that developing countries have strong belief in cascading tariff structure to promote local production, type of import goods would be dominated by intermediates used for finished goods production. It would be difficult to find close substitute products in domestic market. The expected disciplining effect would be limited. It is possible to have finished goods imports but they are likely to be totally different from locally manufactured ones. As reflected in the previous studies (Kokko, 1994; Moran, 1998), high nominal protection encourages the entry of local enterprises but they might focus certain niches that are not directly competing with imports.

13. By contrast, in the production network, the disciplining effect would be stronger. Decision to fragment the whole production process\(in-house vs. outsourced), where to be produced (home vs. aboard) is systematically determined to ensure the cost competiveness of final goods. Hence, oligopolistic responses like change output level in responses to import changes are less likely to work in the network trade.

14. Regard to the disciplining effect (pressure on prices) competition found at the final goods between leading MNEs can easily pass through to each stage of production in the network. Inefficiency occurring in any stage of production can create significant impact on final goods competitiveness. It is in line with the effect of tariff on production network (Yi, 2003). Hence, firms in the networks must work together to ensure all non-price qualifications are fulfilled given the price target . The joint work even commences before actual production. production.

15. Parts imports could occur in two circumstances; The first is parts imports are used in the later stage of production. However, their output can be classified in the same category under the standard industrial classification like 4-digit ISIC. For example, 7 out of the top 10 of P&C exports are on the top-10 of P&C Imports calculated at the 5 digit SITC level of disaggregation, suggesting the high level of intra-product trade. Hence, the disciplining effect is still observed.

16. The second is the imports are used by specific customers which are in the different industry. Such parts are tailored to specific uses in the later production stage and are not necessarily substitutes to products which are classified in the same category. Even though the second is hard to refute its possibility, it is less likely due to the lucrative sale volumes from the production network. This would encourage domestic enterprises enter and results in an increase in competition.

17. Measure the extent to which the industry participates in the production network The ratio of parts to total goods import values, is used to measure the extent to which the imports are driven by the network trade. We use the list of parts which is a result of a careful disaggregation of trade data based on the Revision 3 of the Standard International Trade Classification (SITC, Rev 3) extracted from the United Nations trade data reporting system (UN Comtrade database) firstly developed in Athukorala (2003) and further extended (adding lists of parts found in the firm interview) in Athukorala & Kohpaiboon (2009)

18. The Model

20. Data Cleaning and Variable Measures Data for the study are compiled from unpublished returns to the Industrial Census 2006, the latest industrial census available, conducted by the National Statistics Office (NSO). After cleaning criteria are applied, the remained samples are 24,696, accounting for 75% of the Thailand’s manufacturing gross output and 62% of manufacturing value added in 2006.

21. The census was cleaned up by • checking duplicated samples. • delete establishments which had not responded to one or more the key questions such as sale value, output and which had provided seemingly unrealistic information such as negative output value. • Delete micro-enterprises defined as the plants with less than 10 workers. • 7 industries that are either to serve niches in the domestic market (e.g. processing of nuclear fuel, manufacture of weapons and ammunition)

22. Econometric Procedure • OLS regression while paying attention on possible effect of outliers and problems emerged from clustered data. • Several robustness tests were undertaken. • Price-cost margin (A ratio of output/value added) • How to measure import penetration (Denominator: including or excluding X) • How to measure the plant’s foreign ownership • Econometric procedure (Quantile vs. OLS regression; 2SLS and 3 SLS for Simultaneity problems)

23. Result: OLS without outliers (Equation 6.3)

24. Discussion on the effect of imports on prices In all specifications and robustness checks (Tables 6 and 7), our finding supports the formulated hypothesis. For the final goods imports (i.e. ), there is a positive relation between PCMV and IMP. When imports surge, domestic firms tend to cut their output to avoid direct competition with the import goods.

25. Note that avoiding direct competition could be done by producing different goods serving for certain niche in the local market. Fabric and machinery are the example. All other things being equal, the disciplining effect of import would be negligible and the positive relationship perhaps reflects extra profit in the relatively less competitive environment there. By contrast, there is the net disciplining effect of import in the production network.

26. In the production network, firms work together long before mass production actually take place to ensure that they reach price target as well as satisfy with non-price qualification. Since the lead firm in the network usually multinational enterprises utilizes their global network in setting price, price setting is approaching to the perfectly competitive market environment, reinforcing the disciplining effect of imports.

27. Conclusion and Policy Inferences Our finding that the stronger disciplining effect is found in the production network highlights benefit of participating in the production network in terms of efficient use of resources. It would be difficult for indigenous firms to participate and enjoy the lucrative sale volume in the network in presence of cascading tariff structure and extensively use of tariff exemption. Rationalizing tariff structure and neutralizing economic incentives are needed.