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A test of Dutch long-run export supply behaviour

Steven Brakman & Elmer Sterken
Published online: 04 Oct 2010.

To cite this article: Steven Brakman & Elmer Sterken (1998) A test of Dutch long-run export supply behaviour, Applied
Economics, 30:3, 383-389, DOI: 10.1080/000368498325903

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 Applied Economics, 1998, 30, 383± 389

A test of Dutch long-run export supply

behaviour
S T E V E N BR A K M A N and E L M ER S T E R K EN
Department of Economics, University of Groningen, PO Box 800, 9700 AV Groningen,
the Netherlands

The small country assumption a€ ects the modelling of the export demand and export
price equations. A large (monopolistic) country can set its export price as a mark-up
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over marginal cost, because it has market power. In contrast, small countries have to
deal with competition which forces prices down to the price level of foreign competi-
tors; prices are exogenous. Another possibility is the case in which a small country
wants to preserve market shares in foreign markets, this results in fully endogenous
pricing. This paper tests the small country export hypothesis for the Dutch economy
using a long-run VAR-model. The estimated VAR-model includes two long-run
equilibrium relationships, which can be identi® ed as an export supply and export
demand equation. Restrictions on the variables are used to test the various hypotheses
concerning the long-run supply relationships.

I. INTRODUCTION of intra-industry trade. A theoretical explanation of this

phenomenon draws on arguments like economies of scale,
Small country macroeconometric models often assume that imperfect competition, product di€ erentiation, etc (see
there is perfect substitutability between domestic and Krugman, 1990). These theoretical and empirical observa-
foreign goods and services. This assumption seems in- tions suggest that even countries that are obviously `small’
tuitively plausible for obvious small countries like the can still exert some market power, making the standard small
Netherlands and has the modelling advantage that a single country assumption dubious. In this respect Dixit (1987, p.
(demand) equation can be estimated for exports or imports. 352) notes that: `If we give due recognition to product
However, sometimes it is assumed that export mark-up diversity, we ® nd that many small countries are non-trivial
pricing takes place, which implies that the same country in the production of, and trade in, speci® c commodities.’
does have some market power (see for instance the Dutch Some indication of the presence of product diversity in
FKSEC-model constructed by the Dutch Central Planning the Netherlands can be derived from the level of intra-
Bureau, 1992). Both empirical assumptions are supported industry trade (see also Van Bergeijk et al., 1992). A measure
by the macro-data (see Brakman and Sterken, 1994, for of intra-industry trade which is widely used because it deals
a survey). However, the `new trade theory’ indicates that the with trade imbalances and is relatively easy to implement is
small country assumption is not undisputed (see Dixit, the so-called Balassa index (Balassa and Bauwens, 1988;
1987). Recent empirical evidence on trade ¯ ows shows that Kol, 1988). 1 The results for SITC 2-digit and 3-digit are
trade between industrial countries consists to a large extent given in Table 1.
1
The Balassa index reads
S i (Xbi + Mbi) - S i |Xbi - Mbi|
(6)
S i (Xib + Mbi )
where
Xi (X + M) Mi (X + M)
Xbi = Mbi =
2X 2M
with X total export of goods, M total import of goods and i the SITC (Standard International Trade Classi® cation) category. Furthermore,
to give some indication whether or not further disaggregation in¯ uences the intra-industry measure we calculated the Balassa index using
both SITC 2-digit and SITC 3-digit ® gures for the years 1988± 92.
0003± 6846 Ó 1998 Routledge 383
 384 S. Brakman and E. Sterken
Table 1. Balassa index for intra-industry trade for the Netherlands Suppose that the export behaviour of a country can be
modelled as a ® rm. This ® rm faces a macroeconomic de-
Year SITC 2-digit SITC 3-digit
mand equation. This demand equation is the sum of indi-
1988 0.777 0.668 vidual demand equations for various products. In a mono-
1989 0.776 0.667 polistic market a small country is only one of a few suppliers
1990 0.783 0.680 of the set of goods and possibly the only one. In a competi-
1991 0.772 0.667 tive market the country faces the competition of other
1992 0.794 0.692
suppliers willing to produce the same set of goods. We
assume that, in both cases, the total demand for the export
bundle increases as soon as prices fall.2 Suppose the demand
for the export good xd is driven by its own price p:
Table 1 shows that the amount of intra-industry trade is
relatively constant over time, a lower level of aggregation x d = f (p) (1)
reduces the amount of intra-industry trade somewhat The locus of the demand equation is driven by the income of
(which should be expected) and, most important for our the buyers, represented by world trade bc and the price of
purpose, both levels of aggregation indicate that a substan- competing goods pc (goods of the same quality sold by
tial part of trade is intra-industry. The hypothesis that the competitors on foreign markets).
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Netherlands has market power in foreign markets seems
a priori warranted.
In this paper we test for the small country assumption
using the Dutch case as an example. We present an unre-
stricted VAR-model of the export market and try to pin
down a long-run export supply equation and a long-run
demand equation for the Netherlands. We sum up with
a conclusion.
I I . TH E M O D E L
Three model versions might be relevant.
(1) The large country model, in which the home exporter
has market power.
(2) The small country model under pro® t maximization and
full competition in supply.
(3) The small country model under market share stabiliz-
ation and full competition.
The country has the problem of choosing its export price
p. If the market is monopolistic, exporters can set the price
at a pro® t maximizing level. It can be shown that in a model
with a double logarithmic speci® cation, pro® t maxim-
ization leads to a mark-up relation
p= c- log (1 - 1/e ) (2)
where c represents (the log of ) marginal costs and e is
constant in the double logarithmic model.3 We use this
framework to illustrate the three possible model versions.
· The home exporter has market power. This implies that
the home country is able to act as a price setter and that
the export price will not necessarily equal the price
charged by competitors of related products. The export
price is set at the pro® t maximizing level on the downward
sloping demand curve and is therefore endogenous. More-
over, the export price will be driven by a mark-up mecha-
nism over marginal costs, and is determined by domestic
rather than by foreign prices. The appropriate model for

2
We take lower case symbols to represent natural logs. This transformation has the advantage of allowing the interpretation of the
parameters (elasticities). A drawback is the alleged constancy of the price elasticity.
3
Given a cost function C(xd) in levels for the sake of convenience, the pricing mark-up equals

1 2
¶ P Xd ¶ C(Xd)
P 1+ = (7)
¶ Xd P ¶ Xd
The export price is set as a mark-up over marginal costs. The mark-up is determined by the market power of the ® rm. Let the price
elasticity of demand be given by
¶ Xd P
e = - (8)
¶ P Xd
The price equation can be rewritten as

1 2
1 ¶ C(Xd)
P 1 - = (9)
e ¶ Xd
Note, that for large e the export price will tend towards marginal cost. Taking logs give Equation (2).
 T est of Dutch long-run export supply behaviour
the large country case is therefore a downward-sloping
demand curve combined with a mark-up export price
equation. 4
· Suppose we are in a world with extensive competition in
the market of home’s export good. That is, there is a large
number of the producers, home and abroad, willing to
supply the goods that the country wishes to export. There
is full competition on the supply side; on the demand side
we face a downward-sloping curve. In this case the coun-
try cannot set its export price, because e is large (in® nite).
It has to take the price as given at a level that is forced
upon it by market competition and pro® t maximization,
that is, due to entry and exit of ® rms output will be
adjusted so that the price equals marginal costs (and
minimum average cost at the minimal e cient scale). If it
asks a higher price than foreign competitors exports will
tend to zero, while a lower price gives an in® nite demand
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for the bundle. An exogenous shock in the demand for
exports will not lead to a change in export prices. The
export price equals marginal cost and cannot diverge
from the price of foreign competitors. In this case the
appropriate model is an export supply equation, which
equals the export price (and marginal costs) to competi-
tive export prices.
· The third possibility is also a competitive market case (a
small country), with a home supplier that is willing to
accept losses in the short run. The idea is that changes in
market shares are more expensive than price changes. In
this situation the export price will not, as a rule, equal
marginal costs or follow prices of competitors. Instead,
the exporting country sets a target with respect to export
quantities and world demand dictates the corresponding
export price. This might result in temporary losses as the
export price might not be high enough to cover marginal
costs. In fact, we have a vertical supply curve (export
quantity is given) in the (p, xd)-space.
I I I . E M P I R I C A L I M P L E M EN T A T I O N
We use data for the Netherlands covering 1975.I± 1995.II
including a period with both current account de® cits
(around 1980) and surpluses (the last decade). We use ex-
ports (excluding natural gas) x, its price index p, double
weighted competitive world trade bc and its price index pc ,
unit labour costs as a proxy for marginal costs c and the
utilization rate qx in order to include the home-pressure-of-
demand e€ ect.5
4
For e with |e | < 1 the mark-up will be negative. The double logarithmic model yields a constant e . For values of e absolutely smaller than
unity the interpretation of a monopolistic setting is troublesome. See also Equation (2).
5
See Jacobs et al. (1993) for a description of the data.
6
We include signi® cant lags in the unit root equations as long as the DW-statistic is close to 2. We have deseasonalized the variables using
additive correction prior to testing.
7
We followed strictly the software package CATS (see Hansen and Juselius, 1995).
385
The data are used both to identify demand and supply for
export goods and to discriminate between the three models
of export supply. In order to tackle this classical identi® ca-
tion/discrimination problem we ® rst use a VAR-model to
identify the long-run properties of the data. We then impose
over-identifying restrictions on the long-run equilibrium rela-
tions in order to discriminate between models. But ® rst the
individual time-series properties of the data are investigated.
Individual integration properties
As usual, prior to testing for co-integration between the
variables, which in our case are export prices, marginal
costs, exports, competitive trade and a home-pressure-of -
demand variable measured by capacity utilization, qx, we
determine the order of integration of the variables (see Engle
and Granger, 1987). Table 2 contains the main test results.6
With a constant and trend variable the 5% con® dence
level is about - 3.47, with a constant about - 2.90 and
without a trend or constant about - 1.95 for this sample
size. We can conclude from Table 2 that all variables,
including our transformations x - bc, p - pc , p - c and
pc - c, except for qx are I(1). In most studies export is related
to double-weighted world trade, (x - bc), implying that
bc has an export elasticity of one. The same holds, mutatis
mutandis, for the elasticity of the home export price with
respect to double-weighted competitors’ prices (p - pc). This
re¯ ects the idea that it is important to correct the foreign
income and price variables for the trade structure of the
country involved (i.e double-weighting). For example, total
world demand for exports in general is not the relevant
income variable, but only that part which corresponds to
the countries’ export structure. The mark-up (p - c) is used
as an indicator of monopolistic competiton (see below). As
Table 2 shows, the transformations are all of order I(1). This
conclusion has some direct implications for both the con-
stant market share model and the horizontal supply model.
First, X/Bc being not constant apparently disquali® es the
constant market share model. Second, with full foreign
competition P/Pc should be constant too.
Cointe gration and long-run equilibrium
In order to characterize the long-run equilibrium relations
between the variables mentioned we start with the following
unrestricted VAR model with Gaussian errors7
zt = A 1 zt ± 1 +¼ + A k zt ± k + m + C D t + n t (3)
 386
where zt is the (4, 1) vector of the variables: exports (cor-
rected for natural gas) x minus double-weighted competitive
world trade bc , the domestic export price p minus the com-
petitive export price pc , the domestic mark up as the export
price p minus the domestic marginal costs c, the cost level
itself c in order to identify the individual parameters. The
utilization rate qx is included in the model as weakly
exogenous variable (see hereafter). As explained above, we
assume that there is homogeneity of export demand with
respect to foreign income. This has been found in other
empirical studies (see Central Planning Bureau, 1992). Dt is
a vector of non stochastic variables, which can be excluded
from the cointegration space, for which we implemented
two dummy variables for the four quarters of 1980 and
1986. In 1980 a sharp increase in prices can be seen, while in
1986 world export prices fell. n t is niid (0, S ) . The model is
reformulated in error-correction form:
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S. Brakman and E. Sterken
The hypothesis of cointegration is formulated as a re-
duced rank of the P -matrix:
H 1 (r) : P =a b 9 (5)
where a and b are (4, r) matrices of full rank. The hypothesis
implies that b 9 zt and D zt are stationary, while zt needs not to
be stationary. b includes the cointegrating vectors, a repres-
ents the weights of the cointegrating vectors in the VAR-
model. r is the number of cointegrating vectors, which is
identical to the cointegration rank.
We estimated the VAR using eight quarterly lags to
assure normality of the residuals. As is known, the Johan-
sen-procedure is rather sensitive to the assumed distribution
of the variables. Prior to the determination of the cointegra-
tion rank we tested for weak exogeneity. It appears that with
a rank equal to 2, qx is weakly exogenous. Therefore we
proceed with a four-dimensional VAR. The unrestricted

model yields a two-dimensional cointegration space accord-

D zt = G 1D zt ± 1+ ¼ + G k ± 1 D zt ± k+ 1
ing to Table 3. A test on normality of the residuals yields
+ P zt ± 1 + m + C Dt + n t (4) a x 2 (10) = 5.86, which does not reject normality at the 95
per cent con® dence interval. The unrestricted long-run vec-
The matrix P contains information about long-run rela-
tors are given in Table 4. We normalized the ® rst vector on
tionships between the variables in the data vector. Johansen
x - bc and the second on p - pc. Note that the results have
(1988) distinguishes three possible cases:
a pure statistical character. The vectors found do not need
· Rank(P ) = 4, i.e. the matrix P has full rank, indicating to represent economic relationships. It is likely though that
that the vector process zt is stationary; they are transformations of economic long-run equilibrium
· Rank( P ) = 0, i.e. the model reduces to a traditional VAR- conditions. Therefore, we need to identify the model. Note
model in ® rst di€ erences; that any linear combination of the two long-run vectors is
· Rank( P ) = r < 4, implying that there are 4xr-matrices also a cointegrating vector.
a and b such that P = a b 9 .
Identi® cation of the long-run model
Table 2. Unit-root tests
Once we have established the basic long-run equilibrium
Levels ADF(c, t, i) D ADF(c, t, i) model between x - bc , p - pc , p - c, c and the weakly
exogenous utilization rate qx , we come to the identi® cation
xd - 3.04 (c, t, 4) - 7.72 (c, 2) of the proper model. Exact identi® cation of the VAR model
bc - 1.97 (c, t, 2) - 9.63 (c, 0) needs a partitioning of the four endogenous variables into
p - 2.39 (c, 4) - 3.55 (4)
a set of two fully endogenous variables and two weakly
pc - 1.86 (c, 4) - 3.74 (3)
c - 2.03 (c, 4) - 2.90 (3) exogenous variables. Moreover, we should be able to ex-
qx - 3.97 (c, 1) clude one endogenous variable from the ® rst equation and
x - bc - 2.50 (c, t, 3) - 10.50 (c, 2) the other endogenous variable from the second one. As
p - pc - 1.52 (0) - 9.76 (0) this procedure prevents us from an interpretation in
p- c - 0.71 (2) - 4.88 (1)
pc - c - 1.17 (2) - 4.90 (1) terms of a supply and demand model we proceed with
a more standard identi® cation routine by separating the
Lags between parentheses. Sample: 1975.I-1995.II exogenous variables. Testing for exogeneity shows that in

Table 3. Cointegration rank of the unrestricted model

Eigenvalue l max Trace H0 : r p - r l 90

max Trace9 0

0.5732 63.00 123.37 0 4 18.03 49.92

0.4589 45.45 60.37 1 3 14.09 31.88
0.1762 14.34 14.93 2 2 10.29 17.79
0.0079 0.59 0.59 3 1 7.50 7.50

E€ ective sample: 1977.I± 1995.II

 T est of Dutch long-run export supply behaviour 387
Table 4. Cointegrating vectors with unrestricted b

x - bc p - pc p - c c qx CON

1.000 0.654 - 0.260 0.069 - 0.155 - 6.444

2.705 1.000 - 0.810 - 1.097 0.029 - 11.299
E€ ective sample: 1977.I± 1995.II

Table 5. Cointegration rank of the partitioned model

Eigenvalue l max Trace H0 : r p - r l

90
max Trace9 0

0.5540 59.76 73.32 0 2 10.29 17.79

0.1675 13.57 13.57 1 1 7.50 7.50

E€ ective sample: 1977.I± 1995.II

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Table 6. Cointegrating vectors in the partitioned model

x - bc p - pc p - c c qx CON

1.000 0.584 - 0.274 - 0.058 - 0.108 - 5.834

7.821 1.000 0.140 0.311 - 1.546 - 49.303
E€ ective sample: 1977.I± 1995.II

a one-dimensional cointegration space the mark-up p - c
and domestic costs c are weakly exogenous. So we partition
zt into zt = (yt, xt) with the endogenous variables yt =
(x - bc, p - pc). The corresponding VAR gives the l - and
trace statistics and corresponding unrestricted long-run vec-
tors shown in Tables 5 and 6. The model passes tests on
normality of the estimated residuals: x 2 (4) = 0.74.
Our basic model suggests that the ® rst cointegrating
vector represents demand for export goods and the second
cointegrating vector represents supply. The demand rela-
tion is expected to be dominated by the price competition
p - pc and not by domestic cost factors like the mark-up
p - c, costs c or the utilization rate qx. For the supply side
we have three possibilities: the vertical supply curve, the
horizontal supply curve and the monopolistic mark-up
model.
· In the vertical supply curve model ® rst the market share is
determined upon. After that, the demand function deter-
mines the export price. In terms of the supply function we
have two testable hypotheses:
1. The market share on foreign markets X/Bc is relevant
in the determination of the export price. This implies
that x - bc cannot be excluded from the supply equa-
tion.
2. Domestic mark-up or costs are irrelevant. This
implies that neither (p - c) nor c can enter the supply
equation.
3. Also, market shares of tradable goods on home mar-
kets might be relevant. This home-pressure-of-deman d
is measured by the utilization rate; if qx increases
export prices will also increase.
· In the horizontal supply model foreign prices dominate
domestic prices. Domestic costs and the mark-up cannot
have any impact on the export price. Therefore, the supply
relation can be restricted to a p - pc-equation. In the
long-run supply equation the mark-up p - c and cost
variable c can be excluded. This means that the horizontal
supply model is almost observable and equivalent to the
vertical supply model with respect to the inclusion of
p - c and/or c.
· In the monopolistic model we should observe complete
endogeneity of both export price and quantity. Moreover,
the mark-up price relation p = c - log(1 - 1/e ) indicates
that price setting is fully contingent on domestic costs and
not on foreign prices. Domestic utilization might play
a role in the determination of the mark-up, because, in
practice, a constant mark-up over marginal costs could be
too restrictive. An increase in the utilization could lead to
higher prices, while low capacity utilization could enforce
discounts.
We test for these model versions by simultaneously
imposing identifying restrictions on demand and supply
equations. First, we test for the exclusion of the mark-up
and costs from the model in both equations. Moreover, we
 388
Table 7. Cointegrating vectors in the monopolistic model
x - bc p - pc p - c c qx
1.000 0.174 0.000 0.000
0.000 1.000 - 0.669 - 0.142
E€ ective sample: 1977.I± 1995.II
exclude the utilization rate from the supposed export de-
mand equation. The x 2 (4) of 34.10 indicates a rejection of
these restrictions on the model. This implies that the mark-
up does play a role in the model and suggests that we can
reject both the horizontal and vertical supply model.
Next we estimate a model with a mark-up in the supply
equation. This model can underpin the monopolistic model.
Table (7) gives the results. The x 2 (2) = 1.67 reveals proper
identi® cation restrictions. Furthermore, both the demand
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and supply equations are intuitively appealing. The demand
relation has a standard negative slope and, in the supply
equation, higher relative prices on export markets are deter-
mined by higher mark-ups and higher costs. However, the
empirical results also reveal some problems. First, the im-
plied long-run export demand price elasticity is small
( - 0.17). This makes a direct interpretation of a constant
mark-up troublesome. Second, the inclusion of a capacity
utilization variable might imply that a constant mark-up
model is too restrictive; periods with high or low capacity
utilization rates have di€ erent mark-ups. Closer inspection
of the data reveals that the last two decades show a struc-
tural downward shift in mark-ups; the average p - c in
the subsample 1975.I± 1985.IV was 0.076, while in the
1987.I± 1995.II subperiod it reached - 0.200. Furthermore,
the model can be incomplete in the sense that the inclusion
of a capacity utilization variable indicates that the domestic
market is also important. The quantities traded on foreign
and domestic markets are not independent, since (marginal)
costs are determined by total sales. Finally, measures of
marginal costs are notoriously di cult to obtain as ac-
counting data on costs in general do not equal marginal
costs. And, one might add, if imperfect competition reigns,
di€ erent products will have di€ erent marginal costs and
therefore di€ erent prices. These criticisms are valid, but they
also point at further disaggregation of the data, which is not
the purpose of macroeconometric modelling.
Despite the small price elasticity of the export demand
equation and a possible incompleteness of the model we ® nd
some support for the monopolistic model. This would imply
that the Netherlands is not a small country, but has some
power on export markets.
IV . SUMMARY AND CONCLUSIONS
In macroeconometric studies it is not always clear whether
one deals with a large or a small country. It is often assumed
S. Brakman and E. Sterken
CON
0.000 - 6.106
- 0.268 0.659
a priori whether the country under consideration is small or
large. In this paper we study the Netherlands, which is
obviously a small country. But an analysis of data on Dutch
intra-industry trade suggests some power on the export
market. Traditional macro-econometric models as em-
ployed in the Netherlands include equations for Dutch
export demand in which it is often implicitly assumed that
the Netherlands are small. The corresponding estimation
techniques assume perfectly elastic supply. Consequently, it
su ces to estimate a single-equation demand model. At the
same time, export prices are a hybrid mix of competitor
prices and costs, which seems to indicate some market
power. Usually these equations are estimated separately
from the export demand equation. Therefore, it is interest-
ing to test both the market structure and ® rm behaviour
simultaneously on the market for export goods. We test
three models:
(i) a small country model with market share stabilization
(vertical supply curve);
(ii) a small country model with full competition and pro® t
maximization (horizontal supply curve);
(iii) a large country model (monopolistic model).
The empirical results are based on the estimation of a VAR-
model. The VAR includes two long-run equilibrium rela-
tionships, which can be identi® ed as a supply and demand
equation. Using identifying restrictions on the model we test
for di€ erent model versions. The results show that a simple
demand equation for Dutch exports can be identi® ed to-
gether with a price-setting relation in which a mark-up is an
important determinant. The inclusion of a mark-up variable
leads us to dismiss the small country assumption for the
Netherlands.
AC K N O W L E D G E M EN T S
We would like to thank Harry Oldersma for providing the
data on intra-industry trade, Jan Jacobs, Simon Kuipers,
Charles van Marrewijk and Bert Schoonbeek for comments
on an earlier version of the paper.
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