The structures of product and labour markets have important implications for the effectiveness of macroeconomic stabilization policies and for international macroeconomic interdependence. High and persistent unemployment in the 1980s prompted a number of studies of labour market structure for the OECD economies, but there are few comparable studies for product markets. In `specialized production' models, each country produces a single imperfect substitute for foreign-produced goods, and attention focuses on the ratio of countries' GDP deflators. In `non-traded goods' models, countries also produce goods that are internationally non-tradable because of transport costs and trade barriers: more general versions distinguish between `manufactures' and `commodities', which are imperfect and perfect substitutes respectively. Price sluggishness is also an important determinant of the effectiveness of monetary and exchange rate policies, but there is little international evidence on its quantitative importance.

In Discussion Paper No. 486, Research Fellow George Alogoskoufis, Chris Martin and Nikitas Pittis seek to choose between alternative characterizations of product markets and to investigate the role of price sluggishness. In a specialized production model, the GDP deflator depends solely on the marginal variable costs of domestic producers; in a simple non-traded goods model, producer prices depend on foreign prices and domestic marginal costs with elasticities equal to the shares of traded and non-traded goods respectively; while in more general models, producer prices depend on foreign prices and domestic marginal variable costs with elasticities equal to the shares of commodities and the combined shares of non-tradables and manufactures respectively.

Evidence from 20 OECD economies indicates that a model that distinguishes non-traded goods and internationally perfectly substitutable commodities clearly dominates a one-sector model as a description of their product market structures. In the preferred model, the relative price of manufactures vis-à- vis non-traded goods in each country is fixed by the assumption of equal variable costs in the two sectors, which emphasizes the relative prices of manufactures across countries and of manufactures vis-à-vis primary commodities. Nevertheless, direct effects from commodity prices to OECD producer prices are small enough for the specialized production model to remain a reasonable approximation. Finally, price sluggishness is important for all the countries examined, which has important implications for the effectiveness of even anticipated changes in monetary and exchange rate policy.

Pricing and Product Market Structure in Open Economies: An Empirical Test
George Alogoskoufis, Chris Martin and Nikitas Pittis

Discussion Paper No. 486, December 1990 (IM)