Is exchange rate pass-through in pork meat export prices constrained by the supply of live hogs?

Broad globalization pressures and increased concentration in downstream levels of agri-food supply chains have spurred a keen interest in the relationship between competition, export prices, and exchange rates. Exchange Rate Pass-Through (ERPT) can be broadly defined as the export price movement following changes in exchange rates (Bowen, Hollander and Viaene, 1998). Some notable ERPT studies include Pick and Carter's (1994) wheat study, Griffith and Mullen's (2001) analysis about Australia's rice exports, Brown's (2001) analysis of Canadian canola exporters and Miljkovic, Brester, and Marsh's (2003) analysis of U.S. meat exports. Incomplete ERPT implies some form of market power because export prices in different markets are not equal to firms' marginal cost. It does not imply that markets are segmented, however, because imperfect competition is not inconsistent with integrated markets.

One issue that has been neglected in the literature is whether firms have unlimited capacity when adjusting export prices following changes in the exchange rate. Knetter (1994) suggested that export price adjustments were likely to be linked to whether firms face capacity constraints in distribution networks or quantitative restrictions in export markets. In his framework, bottlenecks at the border are revealed through asymmetric adjustment in export prices. Bughin (1996) used panel data from Belgian manufactures to estimate a cost function under potential capacity constraints. He finds that the degree of mark-up adjustment following currency movements is significantly linked to each firm's capacity constraint.

In the context of agricultural supply chains, capacity constraints in downstream agri-food markets can stem from the usual short-run fixity of an input (e.g., stock of capital) or lengthy lags between production and marketing of primary agricultural goods. These lags are especially lengthy in livestock and grain industries whose production decisions precede marketing decisions by several months. For example, currency depreciation may not trigger immediate increases in exports of processed commodities because the supply of upstream producers may be perfectly inelastic in the short run. Moreover, processing firms and agricultural producers have developed different marketing strategies (e.g., contracts) that often include binding commitments with respect to price and output. Hence, even though a processing firm is faced with unexpected and unfavorable movement in the exchange rate, it may sell more output than it would otherwise choose due to binding marketing agreements.

The objectives of the article are twofold. First, a theoretical model that accounts for production and marketing lags is used to explain the pricing decisions of a firm that exports a processed good to two markets. At the marketing stage, the downstream firm's capacity may be predetermined due to the inelastic supply of the primary agricultural commodity or because of committed purchases of the primary input. We refer to these scenarios as a capacity constraint from the processing firm's perspective. If the capacity constraint is not binding and there are constant returns to scale in processing, the mark-up of the firm in a given export market reduces to the standard monopoly pricing rule. If the capacity constraint is binding, the destination-specific mark-up of the firm is a function not only of the exchange rate in that particular market, but also of the exchange rate in the other export market.

The second objective is to measure ERPT in pork meat export prices from three Canadian provinces (Ontario, Quebec, and Manitoba) to two destinations (United States and Japan) over the 1988-2003 period. The empirical model of Knetter (1989, 1993) is modified to test the theoretical finding that if export prices of processed pork meat are constrained by the supply of live hogs, the number of hogs slaughtered and the exchange rate in the other market should explain export pricing decisions. The idea is to use an empirical model that can identify long-run effects of predetermined supplies from short-term effects due to bottlenecks and/or frictions in supply chains that error correct in the long run.

There are two main empirical challenges when estimating ERPT in Canadian pork export prices. First, it is not unusual to find that export prices and exchange rates possess a unit root (see, for example, Carew and Florkowski 2003; Choudhri, Faruqee, and Hakura 2005). As such, the empirical model must account for the potential nonstationarity in the data when estimating the model. Second, efficiency gains in the estimation can be captured by estimating the ERPT equation of each province to a given market simultaneously. These two issues are addressed by using the Dynamic Seemingly Unrelated Regression (DSUR) model proposed by Mark, Ogaki and Sul (2005) and Moon and Perron (2004). The estimation procedure involves two steps. First, leads and lags of the independent variables and a generalized least squares (GLS) estimator are used to correct, respectively, for potential endogeneity bias and autocorrelation in the residuals. In the second stage, restrictions on the cointegrating vectors are accounted for using the minimum distance estimation method proposed by Moon and Perron (2004).

The results suggest that pork packers' volumes in Quebec and Ontario have significant impacts on export prices while there is no evidence of this being the case for Manitoba. The empirical model also reveals significant differences between estimates of ERPT accounting for lags in production and marketing decisions and the ones obtained using a standard specification that implicitly assumes instantaneous adjustment in output. The ERPT elasticities are statistically different than zero and thus suggest that Canadian pork exporters adjust their margin in response to fluctuations in the relative value of currencies.

The remainder of the article is structured as follows. The next section presents a theoretical model that explains pricing decisions in a framework that accounts for marketing lags in agri-food supply chains. The section titled "Data" investigates the statistical properties of the variables used in the empirical model. The section titled "The Empirical Model" presents the econometric procedures and discusses the estimation results. Concluding remarks are presented in the last section.

The Theoretical Model

Consider a processing firm that exports pork meat to two segmented foreign markets, identified by a and b. The demand in each market for the domestic firm's output is: [D.sup.a]([e.sup.a] [p.sup.a], [[bar.p].sup.a]) and [D.sup.b]([e.sup.b] [p.sup.b], [[bar.p].sup.b]), where [[bar.p].sup.j] is the price set in market j by the domestic firm (in domestic currency) and [e.sup.j] is the exchange rate defined as the value of country j's currency per unit of domestic currency. The variable [[bar.p].sup.j] is the price level of foreign substitute products in market j. The model uses the Armington assumption and purposely avoids modeling the interaction between the domestic and foreign firms) This assumption is made for analytical convenience but does not qualify the result, given that the emphasis of the article is not to relate the degree of ERPT to market structure.

The processing firm maximizes profits defined as

(1) [pi] = ([p.sup.a] - [t.sup.a])[D.sup.a]([e.sup.a] [p.sup.a], [[bar].sup.a]) + ([p.sup.b] - [t.sup.b])[D.sup.b]([e.sup.b][p.sup.b], [[bar].sup.b]) - [r.sup.p][Q.sup.p],

where [t.sup.j] measures the transportation cost between the domestic market and destination j, [r.sup.p] is the price of live hogs paid to domestic hog producers, and [Q.sup.p] represents live hogs that are purchased by the firm. Processing marginal costs are assumed constant and normalized to zero.

There are many ways to secure a desired supply of live hogs for the processing firm. The current analysis will focus on two hog marketing mechanisms: (1) the processor relies on the spot market to purchase hogs; and (2) contracts between the processor and individual hog suppliers specify quantities to be delivered and the price that will be paid upon delivery. Additional assumptions about hog marketing arrangements are that (1) live hogs are homogenous products (unlike the processed commodity); (2) hog producers are price takers in the world market; and (3) the domestic firm has monopsony power in the domestic market when purchasing live hogs.

The above assumptions are not unrealistic in the context of the Canadian hog/pork industry (Larue, Gervais, and Lapan 2004), but also apply to numerous other sectors that experienced increased concentration in downstream market levels. Assume that market a is closer to the domestic country than market b such that [t.sup.a] < [t.sup.b]. If the processing firm relies on the spot market to buy live hogs, it can capture all of the available domestic output (denoted by [Q.sup.r]) at a price of [e.sup.a][r.sup.a] - [mu][t.sup.a], where [r.sup.a] is the price of live hogs in country a's currency and [mu] is an adjustment factor between transportation costs of the processed and primary commodities. As Larue, Gervais, and Lapan (2004) argue, the possibility of a hold-up by the processing firm is constrained by the existence of an export market for the primary commodity. There is the possibility, however, that not enough hogs are produced from the processor's perspective because rational hog producers anticipate that the best price they will receive is the price in market a adjusted for transportation costs.