Does value chain integration dampen producer price developments? Evidence from the European Union

• Author: Agnes Kuegler,Klaus S. Friesenbichler,Andreas Reinstaller
• Published date: 01 January 2021
• DOI: http://doi.org/10.1111/twec.12993
• Date: 01 January 2021

World Econ. 2021;44:89–106. wileyonlinelibrary.com/journal/twec

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89

© 2020 John Wiley & Sons Ltd

Received: 7 August 2019

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Revised: 26 February 2020

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Accepted: 4 June 2020

DOI: 10.1111/twec.12993

ORIGINAL ARTICLE

Does value chain integration dampen producer price

developments? Evidence from the European Union

Klaus S.Friesenbichler

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AgnesKuegler

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AndreasReinstaller

Austrian Institute of Economic Research (WIFO), Vienna, Austria

Funding information

Horizon 2020 Framework Programme; European Commission, DG GROW within the Framework Service, Grant/Award

Number: ENTR and /300/PP/2013/FC

KEYWORDS

EU integration, inflation, producer prices, Single Market, value chains

1

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INTRODUCTION

Economic integration, in particular through value chain trade, should help cutting prices. Prices of

goods and services should fall because of increased competition and a more efficient allocation of

resources in an integrated economic area (Melitz & Ottaviano,2008). In addition, increased market

integration is thought to lead to a decoupling of domestic demand and production capacity, thereby

limiting the possibility that inflation rises as domestic demand builds up (Dexter, Levi, & Nault,2005;

Goldberg & Verboven,2005).

This paper sets out to test this conjecture. It uses the Single Market of the EU as an example of an

economically integrated area. We study value chains acting as transmission channels through which

Single Market integration affects producer prices at the sector level. We use a novel set of indicators

to capture different aspects of value chain trade integration. The analysis controls for other layers of

integration: Eurozone membership and the effect of EU accession. These capture additional legal and

institutional aspects of market integration. Hence, the paper empirically extends previous research,

which either focused on inputs, such as raw materials, or differences between broadly defined sectors

such as tradables and non-tradables.

The contribution to the literature is threefold: first, the paper establishes an empirical link between

the cumulated effects of trade integration along value chains and producer price dynamics. Trade theory

predicts that greater trade openness is accompanied by falling prices (Melitz & Ottaviano,2008). This

would imply that economic integration goes also along with lower inflation rates. Recent theorising and

empirical analyses of trade have explained firm level price dynamics either through firm productivity on

the supply-side (Luttmer,2007; Melitz,2003) or final consumer preferences on the demand side (Foster

& Potts,2006). While there is some evidence for a few countries that trade openness reduces prices

(Chen,2009), little is known on how such direct effects cumulate along value chains. The accession to a

large common market triggers a restructuring of supply relations and changes preferences, which we use

in this paper to study this underexposed aspect of market integration. The analysis distinguishes between

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FRIESENBICHLER Et aL.

forward and backward integration and also controls for possible endogeneity issues with respect to EU

accession. Hence, the results contribute to the development of a better understanding of the impact of

market integration on macroeconomic price dynamics (Angeloni etal.,2006).

Second, we address the issue of quantifying value chain integration, thus contributing to the toolset of

applied economic research. We explicitly consider both upstream and downstream effects over the value

chain. In upstream relationships, prices are determined by prices of inputs incorporated in production. In

downstream relationships, prices may be affected by complementarities between inputs or non-constant

returns to scale. Our analysis considers both channels. We draw on the World Input-Output Database

(WIOD) to construct measures of both backward and forward linkages at the country-sector level for the

period 2000–14. This allows for a nuanced discussion of the effects of integration on producer prices. In

addition, we control for EU accession, which affects institutions as well as policy decisions and joining

the Eurozone, which implies entering a pegged exchange rate regime. Thus, we propose a comprehen-

sive, novel and easily reproducible set of EU market integration indicators.

Third, this paper is policy relevant. One of the arguably biggest achievements of the EU is the establish-

ment of the Single Market, which it defines as ‘one territory without any internal borders or other regula-

tory obstacles to the free movement of goods and services. A functioning Single Market stimulates

competition and trade, improves efficiency, raises quality, and helps cut prices.’ (Cit. DG Growth).1 Yet, an

empirical test that market integration helps cutting prices is yet lacking, even though this question is highly

relevant for the debate about economic integration and value chain trade (dis-)integration processes.

2

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PRODUCER PRICES, TRADE AND MARKET

INTEGRATION IN THE EU

Theory predicts a negative effect of trade on prices. As markets become bigger and product variety

and the number of firms increases, competition rises, and firms gain lower mark-ups. Increasing mar-

ket efficiency implies a dampening effect on prices (Melitz & Ottaviano,2008).

A first descriptive analyses of producer price inflation hints at significant heterogeneity between

sector types and countries. Starting with sector-specific price indices Figure1 splits the economy into

broadly defined non-tradable and tradable sectors (Sachs & Larraine,1993; see online Appendix S1).

The main benefits of the Single Market unfold through the trade of commodities. If market integration

indeed has a taming effect on producer price inflation, one would expect that in economies in which

the tradable sector has a larger share in value added producer price inflation should be lower. However,

the data show heterogeneous price developments across countries and sectors (see also Appendix S1).

Price increases tend to be higher in CEE countries than in core European or countries in Southern

Europe. The price developments of tradables and non-tradables are remarkably similar in the bulk of

countries of the sample. However, especially in Finland, Romania, Latvia, Slovakia and the Czech

Republic the producer prices of non-tradables seem to increase faster than in tradables.2

1See https://ec.europa.eu/growt h/single-market_en (accessed on 28 June 2019).

2The price indices have been calculated in a stepwise procedure. First, we define deterministic industry weights, and calculate the

share of tradables and non-tradables for the entire period analysed (2000–14). The total deflated value added produced by each

sector is computed and then weighted by the overall value added. Second, these time- and country-invariant industry weights are

used to compute the aggregate shares of tradables and non-tradables. Due to missing values in some countries’ samples, the

sections T (Activities of households as employers; undifferentiated goods- and services-producing activities of households for

own use) and U (Activities of extraterritorial organisations and bodies) are not considered. Third, the deflators are recalculated so

that they use the year 2000 as the common base. These indices then allow comparing the price dynamics of both tradables and

non-tradables. To illustrate the differences, we use the geometric average over time to show annualised inflation rates.