TESTING INTERNATIONAL PRICE TRANSMISSION UNDER ...

Empirical Tests for Spatial Price Analysis
integration), in which both market integration and a competitive equilibrium are
verified, and are not capable of fully capturing the “messy” character of market
relationships.
Nevertheless, also “these methodological enhancements are no panacea”
(Barrett 2001, p. 25). In fact, switching regime models have some common
drawbacks. They are not dynamic, i.e. only offer static comparisons between the
prices, and do not contain information about the speed of adjustment of prices; in
addition to this, when trade data are not considered, violations of the spatial
arbitrage conditions indicate lack of market integration irrespective of its causes.
But a fundamental problem associated with switching regime models is that the
believability of regime interpretation rests on “very strong and rather unrealistic”
underlying distributional assumptions about which the economic theory has little
to say (Barrett 2001 p.25; Fackler and Goodwin 2001, p.1012; Dercon 1999,
p.2) 26 .
3.2.4 Rational expectations models
The hypothesis behind the use of rational expectations models is that, since
price linkages are not contemporaneous and may involve lags, agents have
expectations that they must formulate about prices at the time of delivery.
Goodwin et al. (1990) develop a rational expectation version of the LOP.
Recalling equation 2.6 (see also note 7 of chapter 2), if we admit that delivery lags
are different, such as in the case where k = 0 and j > 0, we will have
{ P }
P +
1t = β E
(3.23)
0 t 2t
j
That is simply the LOP holding when rational expectations are considered.
3.3 The use of cointegration techniques in spatial price transmission
Cointegration models presuppose that observable variables exhibiting
nonstationary behaviour will nonetheless maintain long-run relationships. The
residuals from such long run relationships are stationary. In our case, the long-run
relationship is nothing but the LOP, which is assumed to be valid in the long run
despite prices being allowed to diverge from it in the short run. In fact,
26 For example, in Sexton’s interpretation, the assumption of independent errors is difficult to understand,
since it implies that there is no process of adjustment to the arbitrage errors. In the Baulch one, the same can
be said for the assumption of a half-normal distribution inside the parity bounds, since it implies a higher
density near the parity bound, even though the markets are not connected at that moment in time; an identical
distribution of the error inside the parity bound would be more realistic (Dercon and Campenhout 1999, p.4).
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