What is Price Transmission Analysis?
Price transmission analysis measures the effect of prices in one market on prices in another market. For example, if the harvest is above average in a maize surplus area, then the maize price in that area will usually fall. The low price will cause an increased flow of maize from the surplus region to the capital city, as traders try to profit from the price difference, thus lowering the price in the city as well. But the effect of the surplus zone price on the city price may be small if there is a long distance between them or if the roads are poor. The effect may be weak if the city gets most of its maize from another region, or the effect may be limited if there are barriers to free movement (such as an international border) between the surplus zone and the city. Price transmission analysis uses price data to measure various aspects of the relationship between the prices in the two markets.
This analysis can be used to study the relationship between:
- world prices and local prices for a given commodity
- local prices for the same commodity in different cities
- prices of two related commodities in the same market channel (e.g. wheat and flour)
- prices of two competing commodities (maize and sorghum)
In this study, we focus on the effect of the world price of a commodity on the local price of the same commodity. An example would be the effect of the Thai rice price on the price of rice in Maputo. However, the analysis can easily be extended to examine the relationships between pairs of domestic prices, such as the price of maize in Lilongwe and Blantyre.
Price transmission analysis uses price data from at least two markets, that is two cities. It is necessary to have at least 5 years of monthly data in order to identify the relationships between the prices. With additional data, it is possible to expand the analysis. For example, with 10 years of monthly data, one can examine seasonality and the relationship between the two prices. And with data on national or sub-national crop production data, one can include the effect of the size of the harvest on local prices.
The output of price transmission analysis consists of the answers to the following questions:
- Is there a long-term relationship between the prices in the two markets?
- Do prices in market A influence those in market B, the reverse, or do they both influence each other?
- If the price in one market changes by 10%, by how much will it cause the other price to change after one month?
- If the price in one market changes by 10%, by how much will it cause the other price to change in the long run?
- How many months will it take for half of the price change to be transmitted to the other market?
Practical Uses of this Information
There are at least three ways in which the results of price transmission analysis can help in the interpretation of price trends.
First, it can help interpret recent changes in prices in a given market.
- If the analysis shows that there is no relationship between international prices and the local price in question, one can focus on explanations in terms of domestic supply and demand, thus avoiding mistakenly attributing the change to world prices.
- If there is a relationship, the analysis allows you to say how quickly we can expect local prices to react to a change in world prices.
- If there is a relationship between international prices and the local price, the analysis will allow you to say whether the current domestic price is above or below the long-run equilibrium given the international price.
Second, in the context of two domestic prices, it tells us whether market A is influencing market B, or B is influencing A, or if both are influencing each other. This causation analysis helps in understanding and describing trends in local prices.
Third, price transmission analysis may help predict local prices over the next 1-3 months. Information about seasonality, inflation, and trends in international prices can be fed into the model to make projections of local prices over the next few months. The prediction will be better if a) there is a strong relationship between local and international prices, b) if we have enough data to calculate seasonal trends, and c) if production data can be incorporated into the analysis.
Fourth, by looking at the degree of price transmission for many markets and commodities, allows us to identify patterns which can be used to interpret price trends in markets that were not analyzed. For example, we expect transmission to be higher for some commodities (rice and wheat) than others and we expect transmission to be higher for coastal cities of countries with regular imports than for inland cities where there is little trade. If true, this would help interpret the price trends even in markets not included in the analysis.
What Price Transmission Analysis Does Not Tell Us?
Although price transmission analysis is a useful tool for understanding and predicting price trends, it only tells us about the relationship between two prices over time. It does not tell us why the price transmission is strong or weak, fast or slow. This interpretation can only be done with local knowledge of transportation routes, seasonal flows in staple foods, trade and agricultural marketing policies, the availability of foreign exchange and credit, the ease of obtaining permits, and the competition for overland freight, among other factors.