TESTING INTERNATIONAL PRICE TRANSMISSION UNDER ...

Empirical Tests for Spatial Price Analysis
procedure) 28 . In a system with n prices, the number of the cointegration relations
has been considered as an index of the degree of integration of the markets.
Cointegration versions of Ravallion’s model have been proposed, as well
(Alderman 1992; Dercon and Campenhout 1999).
Despite their intuitive appeal, the use of cointegration techniques presents a
number of shortcomings (see Barrett 1996; Miljkovic 1999, pp.132-133).
First of all, it is evident that cointegration is not a necessary condition for
markets to be efficiently integrated, since transaction costs (as well as other
elements not explicitly included in the LOP equation, and then contributing to
price spreads; see paragraph 2.3) could be nonstationary processes 29; 30; 31 . So,
price diverging far from each other could not imply any arbitrage possibility at all:
if transaction costs are non stationary, cointegration is then an unnecessary
condition for market efficiency (Barrett 1996; Mc New and Fackler 1997).
Secondly, if the transaction cost band is large but the price spread remains
within the band, prices could result cointegrated even if markets are actually not
linked, since the difference between the prices would not justify any shipment of
the commodities. This means that, in order to use the cointegration approach,
transaction costs should be small if compared to prices, which is often not the case
for agricultural goods. Barrett (1996, p.827), points out that market segmentation
can arise because of inter-market margins larger than transfer costs (absence of
rational arbitrage) or of margins less than transfer costs (rational absence of
28 Both the Engle-Granger and the Johansen procedure have been extensively used in the empirical literature
(Miljkovic 1999, p. 132). Bivariate Engle Granger cointegration tests only allow pair wise comparisons, and
require one of the two prices to be designated as exogenous. Also, Banejeree et al. (1986 cited Goodwin
1999, p. 118) raise concerns about the potential for small sample biases in parameter estimates obtained from
such two-steps procedure, and the fact that Engle-Granger testing procedures do not have well-defined
limiting distributions. Hall (1989 cited Goodwin 1999, p. 118) notices that Johansen’s multivariate testing
procedure, on the other side, suggests a maximum likelihood estimation procedure that provides estimates of
all the cointegrating vectors existing among a group of variables. This approach uses test statistics that have
an exact limiting distribution that is function of a single parameter.
29 Baffes (1991), in those cases were cointegration between prices doesn’t apply, finds out that the non
stationarity of freight rates could be a possible explanation for the non stationarity of price differentials.
30 Fackler and Goodwin (2001) note that in some alternative models (such as the switching regime model)
price spreads depend on all the shocks; this means that, in order to ensure cointegration, transport rate
stationarity is not sufficient, but also stationarity in excess demand shock differences is needed.
31 By using a simple point location model, Mc New and Fackler (1997) show that neither efficiency nor
market integration necessarily lead to linearly related prices. They demonstrate that, even when transport
rates are assumed to be stationary, in the case where prices in two regions are not cointegrated (and the
underlying forces affecting supply and demand are not as well) arbitrage alone doesn’t guarantee that prices
exhibit cointegration, even if the LOP holds, especially as transport rates increase in size and volatility. This
means that the arbitrage condition is not strong enough to ensure cointegration. As transport rates increase,
and markets are thus less likely to be integrated, price spreads tend not to be stationary and price
cointegration tends to be lower. They conclude that if we want to test the LOP, we need to know which the
cointegration properties of the autarky prices are, that markets are well integrated and that transport rates are
stationary before we can have faith in cointegration tests.
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