Endogenous Pricing to Market and Financing Costs

UCSC Dept. of Economics Working Paper No. 496

32 Pages Posted: 30 Oct 2001

See all articles by Joshua Aizenman

Joshua Aizenman

University of Southern California - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: August 2001

Abstract

This paper explains why relative PPP should hold more tightly in emerging markets, and why pricing to market would be observed more frequently in the OECD countries. It studies the endogenous determination of pricing to market, in a real option model with time dependent transportation costs, where the future terms of trade are random. Allowing time dependent transportation costs adds a dimension of investment to the pre-buying of imports, implying that financial considerations determine the frequency of pricing to market, and the deviations from relative PPP. If the expected discounted cost of last minute delivery is higher than pre-buying, one exercises the option of spot market imports if the realized terms of trade are favorable enough. Pricing to market is observed in countries characterized by low terms of trade volatility and low financing costs. In these circumstances, imports are pre-bought, and the spot market for imports is inactive. In countries where the financing costs and the terms of trade volatility are high, few imports are pre-bought, the price of imports is determined by the realized real exchange rate, and a version of relative PPP holds. With an intermediate level of terms of trade volatility and of financing costs, a mixed regime is observed. If the realized real exchange rate is weak, pricing to market would prevail, increasing consumers' welfare by shielding them from the adverse purchasing power consequences of weak terms of trade. If the realized real exchange rate is favorable enough, more imports are purchased in the spot market, and the relative PPP would hold. Higher financing costs increase the cost of pre-buying imports, reducing thereby the frequency of pricing to market, increasing the expected relative price of imports, reducing the expected deviations from relative PPP, and reducing welfare.

Keywords: pricing to market, trade credits, time dependent

JEL Classification: F15, F36, F41

Suggested Citation

Aizenman, Joshua, Endogenous Pricing to Market and Financing Costs (August 2001). UCSC Dept. of Economics Working Paper No. 496, Available at SSRN: https://ssrn.com/abstract=288976 or http://dx.doi.org/10.2139/ssrn.288976

Joshua Aizenman (Contact Author)

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

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