Trade Policies, Market Structure, and Manufacturing Sector

Performance in Malawi over the period 1967-2002

Hopestone Kayiska Chavula

Macroeconomic Policy DivisionUnited Nations Economic Commission for Africa

Addis AbabaEthiopia

chavula@un.org

1

Abstract

The paper attempts to assess the impact of market structure and the changes in trade policy regimes Malawi is envisaged to have gone through since its independence on economic performance. We adopt the widely accepted theoretical approach to structure–performance modeling which follows the general classes of oligopolistic models by expounding the Kaluwa and Reid (1991) framework. Following Baum (2001), structural breaks are econometrically identified in relation to the changing trade regimes. The results provide evidence that market concentration has a positive impact on price-cost margins throughout the trade regimes while factor inputs have negative impacts on performance. Trade variables, imports and exports also exert a negative impact on price-cost margins despite being insignificant during the SAPs period. However, tariff rates have an insignificant impact across the regimes.

1. INTRODUCTION

In the 1960s and 1970s, the Malawian economy went through periods of high economic performance and periods of economic crisis as has been the case with most developing countries in Africa, Asia, and Latin America. However, when one compares the country’s economic performance over the decades since independence, the Malawian economy is observed to have performed relatively better in the first fifteen years after independence, 1964 -1979 (Njolwa, 1982; Mulaga and Weiss, 1996; and Chirwa, 2003). This is supported by the country’s performance in terms of the share of manufacturing output in gross domestic product (GDP) which increased from 8 percent in 1964 to 12 percent in 1979, with the overall GDP growth rate averaging 5.3 percent per annum over the period (Chirwa, 2003). This early success is associated with the period when the Malawi Government implemented the import substitution industrialisation and the protectionist economic policies, together with the export led agricultural development strategy. Despite the adoption of structural adjustment programmes (SAPs), with trade liberalisation as the main guiding policy instrument, Malawi’s manufacturing sector has remained relatively small and underdeveloped, and its performance remains dismal when compared to the period under protectionist economic policies. It contributed about 14 percent of GDP in 1999 down from 17 percent in 1994, and dropped further to about 11 percent in 2003 (World Trade Organisation (WTO), 2002; Malawi Government, 2004; NSO, 2006). These different trade policy regimes with the existing domestic market structures could have played a significant role in the performance of the sector.

The paper uses econometric analysis to evaluate the impact of changes in economic policies and market structure on the performance of the manufacturing sector in Malawi. It specifically investigates the impact of trade policy changes and market structure on the price-cost margins, using enterprise level data spanning over the period 1967 to 2002 in the

2

manufacturing industries involved in the annual economic survey by the National Statistical Office (NSO). The study could not include data beyond 2002 due to unavailability of consistent datasets after 2002. Despite a growing body of empirical literature on the effects of trade policy changes especially tade liberalisation in most developing and emerging economies, there has been no study, with regard to the author’s knowledge that has looked at the impact of changes in trade policy and market structure on mark-ups since the study by Kaluwa and Reid (1991). This study is to some extent an extension of Kaluwa and Reid (1991) covering the period 1969-1972, which falls within the period when the Malawi Government was implementing the import substitution and protectionist trade policies. As far as the author is concerned this is the first study to carry out such kind of analysis over the different trade regimes Malawi is envisaged to have gone through. Also, despite having knowledge of the periods when specific policies were put in place as stipulated in the following section, this is the first study in Malawi to empirically carry out tests, such as the Clemente-Montañés-Reyes unit-root test, with the aim of identifying the sector’s structural breaks, as a result of the changing policy regimes and initiatives, despite having prior knowledge of when the policies were actually put in place. This is believed to let the data reveal the time when these policy prescriptions had effects on the manufacturing sector’s performance, since it is possible to experience lags between the date a policy is announced and the date of its actual implementation, as well as the adjustment by firms in terms of changing their prices, costs, investment options etc. It is believed that the study results will make a significant contribution towards the design and implementation of policies that will have a significant impact on the development of the sector, especially with regards to its contribution to the growth of the economy. The remainder of the paper is organised as follows: Section 2 provides a brief overview of economic policies and reforms in the manufacturing sector in Malawi. Section 3 reviews the theoretical and empirical literature with the associated hypotheses. Section 4 describes the methodology and the data used for estimation, and Section 5 presents empirical results while Section 5 provides policy prescriptions and concluding remarks.

2. ECONOMIC POLICY REGIMES AND MANUFACTURING PERFORMANCE

Domestic and international trade have mostly been influenced by macroeconomic policies that have evolved over time since the country’s independence in 1964. This policy evolution could easily be categorized into three distinct periods with regard to trade and economic regime change. The early economic policies were motivated by the structuralist view to development which advocated government intervention in the market. The first fifteen years (1964-79) of independence were pre-occupied by import-substitution policies with associated restrictive trade policies with limited emphasis on export-orientation. This period was followed by a transitional regime (1980-93) in which Malawi, as was the case with most African countries pursued a series of structural adjustment reforms which opened up various sectors of the economy with emphasis on export orientation. The third regime (1994-2002), was associated with trade liberalisation making international trade almost free. This is the period of open trade with export promotion and democracy as the political regime moved into the multiparty system of government.2

If we try to relate the different regimes to trade policy strategies, Table 1 shows that the manufacturing sector experienced a significant decline in average growth rates in output in

3

relation to the different trade policy regimes. The table outlines the main policy actions implemented by the Malawi Government, relating the trade policy actions to performance of the manufacturing sector during the associated periods. The statistics in the table support the thinking that the manufacturing sector in Malawi performed relatively better during the import substitution and protectionist policy period (i.e. the period 1964-80), than during and after implementation of economic liberalisation policies.

Table 1: Trade policies and manufacturing performance

Period Trade Policy Actions Manufacturing Average Growth rates

1964-1980 Import Substitution Industrialisation Overvalued exchange rate system – fixed peg Limited tariff protection Non-tariff barriers to trade e.g. import licensing and implicit foreign exchange

rationing. Malawi-Botswana reciprocal trade agreement in 1968. Active government involvement in manufacturing industries. Low and stable inflation and interest rates.

12.65%a

1981-1993 SAPs Period Periodic devaluation of the local currency and liberalisation of interest rates Liberalisation of output prices and limited entry Liberalisation into the manufacturing sector.

2.87%

Introduction of duty drawback system in 1988. Introduction of surtax credit system in 1989 Bilateral trade agreements Reduction in tariffs leading to a maximum of 75 percent in 1994. Elimination of quantitative trade restrictions and foreign exchange rationing. Abolition of exclusive monopoly rights Privatisation of state-owned enterprises Liberalisation of the financial sector and interest rates

1994-2004 Complete Open Economy Regime and export promotion Floatation of the local currency Introduction of Export Processing Zones (EPZ) Reciprocal bilateral trade agreement Base surtax rate reduced to 20% Malawi joined the COMESA free trade area Privatisation of state-owned enterprises. Liberalisation of industry and output/input prices.

-1.01%b

Source: Computed by author based on data from the Reserve Bank of Malawi Financial and Economic Review (Various issues). a was calculated over the period 1973-1981 and b was calculated over the period 1995-2002 due to data unavailability during the time of the study.

2.1 Import substitution period

During the import substitution and protectionist policy period more emphasis was placed on the need for private, competitive and profitable firms, which were regarded to be the engine of growth in the manufacturing sector. More industry protection instruments were employed which emanated from both commercial policy and non-policy or natural barriers. The main objective of policies during this period was to diversify the economy away from the agricultural sector through increased import-substitution industrialisation, thereby generating sustainable employment opportunities (Malawi Government, 1971). This was emphasized through the Government Development Plans (1961-64 and 1965-69), the first Statement of Development Policies (1971-80), the Industrial Development Act of 1966 and the Control of

4

Goods Act of 1968. The development plans and the Acts enforced heavy industrial regulation making incumbent firms enjoy protection from competition in the domestic market. Trade policy was central in pursuant of this import-substitution strategy (Mulaga and Weiss, 1996).

During this period, especially between 1973 and 1980, as shown in Table 1, the manufacturing sector had an average growth rate of 12.65 percent, which is relatively the highest growth rate when compared to the other periods in the table.2 It is observed that the economy became more restrictive especially in the late 1970s, which is suggested to have mainly been motivated by the government’s revenue needs to finance the budget. However, this period is characterized by good financial discipline imposed on public sector enterprises, good macroeconomic management leading economic growth and favourable balance of payment (BOP) position. The growth rate in real GDP was relatively higher in the 1970s than any other period in the post-independence era (Chirwa and Zakeyo, 2003).

2.2 Structural reforms period

The second regime is the reform period between 1981 and 1994 in which the Malawi Government actively implemented SAPs under the auspices of the World Bank and the International Monetary Fund (IMF). This was due to the worsening BOP position of the country’s economy as a result of the oil crisis, acute deterioration of the terms of trade and exacerbation of excess demand for imports originating from deficit financing of public expenditure, and increased external transport costs due to the civil war in Mozambique, which led to the influx of refugees into the country exacerbating the situation further. Partly these developments led to the rise of both the current account and fiscal deficit in the country’s economy.4

The adjustment programs were aimed at diversifying the economic base, ensuring appropriate price and incomes policy, increasing efficiency, improving the policy environment for manufacturing and trade, and restructuring of fiscal budgetary allocation and expenditure (Chirwa and Zakeyo, 2003). It is argued that Malawi went through two phases of policy reforms during this period. The first phase is the period between 1981 and 1986, in which more emphasis was placed on domestic trade policy including fiscal and external stabilisation, restructuring of major state-owned and private enterprises, periodic increases in interest rates and agricultural output prices, limited liberalisation of prices and limited liberalisation of entry into the manufacturing sector (see Ahsan et al. 1999; Mulaga and Weiss, 1996). However, towards the end of this period the economy experienced macroeconomic instability arising partly from increases in international transport costs due to the intensification of the Mozambican civil war and the influx of refugees into the country. These developments are believed to have increased the current account deficit to 13 percent of GDP in 1986 from 7 percent in the previous year (Chirwa, 2003). During this period (1981-1986) the manufacturing growth rate significantly declined to 2.6 percent, which is much lower as compared to the import substitution and trade protectionist policy period discussed earlier.i The second phase, during the same reform period was the one between 1987 and 1994, which was characterised by hesitant liberalisation of trade and tariff policies manifested in high macroeconomic instability and poor sequencing of policies. Economic policies during this period were more inclined towards liberalisation of international and domestic trade. Trade orientation was more in favour of exports through an export promotion strategy as stipulated in the Statement of Government Policies (1987-96). This was accomplished through a continuous reduction in import tariffs as a result of the lowering of

5

trade taxes (Milner and Zgovu, 2003). During both the pre-reform and reform periods, trade policy was central in the design and implementation of economic policies, with more emphasis on the growth of the economy. In this period there was a concerted effort on domestic economy liberalisation, especially with respect to agriculture and the financial sectors. In 1987, through the Agriculture (General Produce) Act, the marketing of smallholder agricultural produce was liberalized allowing the participation of private traders in domestic and export markets. This was followed by the liberalisation of prices for agricultural produce with the exception of maize, cotton and tobacco. In 1990, the marketing of agricultural inputs, that was being done by the Agricultural Development and Marketing Corporation (ADMARC), was deregulated and the phased removal of fertiliser subsidies was completed by 1991. It has been argued that reforms in the agricultural sector were characterized by poor sequencing, with markets being liberalized before deregulation of prices during the period (Chirwa, 2003). With regard to the financial sector, interest rates were liberalised by 1988 and entry into the financial sector was liberalized in 1989, allowing entry of new banks into the sector. These developments are believed to have had a significant impact on the performance of the manufacturing sector since most of the industries were agricultural based, as well as benefits to firms through an increased access to banking and financial services after the liberalisation of the financial sector. Furthermore, entry into manufacturing was also liberalised in 1991 after completion of the phased decontrol of prices.5 However, Table 1 shows that the manufacturing sector experienced a significant decline in performance as measured by growth in manufacturing output shown in Table 1 over the whole 1981-1993 period. The manufacturing sector grew by 2.9 percent on average during this period, which is much lower when compared to manufacturing growth during the first fifteen years after independence.

2.3 Open economy regime

The third policy regime is the post-reform period after 1994 in which the economy became more open to domestic and international trade through tariff reductions under multilateral, regional and bilateral trade agreements. This period is characterised by policy refinements with more emphasis on removing the constraints and rigidities facing, especially, the manufacturing sector. The government eliminated the authority to grant exclusive product rights, revised the duty draw-back system and reduced the scope of industrial licensing requirements to a short list of products during this period. Domestic policies continued to focus on the liberalisation of the agricultural sector as the government removed restrictions that prevented smallholder farmers from producing and marketing high value crops such as burley tobacco in 1995. This was followed by the liberalisation of prices for all agricultural crops except maize in 1996, the year in which the government also reduced the base surtax rate from 25 percent to 20 percent. The government also continued the privatisation of state owned enterprises through the National Privatisation Programme from 1996, despite its suspension in 2001 due to lack of tangible benefits.

This period is also associated with the strengthening of regional integration and trade openness within regional blocs, which included the introduction of manufacturing in the Export Processing Zones (EPZ) schemes, and the signing of several bilateral, regional and multilateral trade agreements especially those related to the Southern African Development Community (SADC) free trade area and African Growth and Opportunity Act (AGOA).6

Also, since February 1994, Malawi adopted a managed float exchange rate regime, which led to further devaluation of the exchange rate. The floatation of the exchange rate was designed to improve the country’s export competitiveness, to provide an efficient foreign exchange allocation mechanism and to dampen speculative attacks on the domestic currency which

6

Source: Milner and Zgovu, 2003

were eminent and became predictable due to the frequent devaluations during the time. This floatation was also designed to restore investor and donor confidence, since it became very difficult for the country to do business with the rest of the world due to the low levels of foreign exchange reserves at that time (Reserve Bank of Malawi, 2006).

Figure 1: Price-cost margins and manufacturing output growth rate trends – 1967-2002

-20

-10

0

10

20

30

40

196719

6819

6919

7019

7119

7219

7319

7419

7519

7619

7719

7819

7919

8019

8119

8219

8319

8419

8519

8619

8719

8819

8919

9019

9119

9219

9319

9419

9519

9619

9719

9819

9920

0020

01

Pric

e-co

st m

argi

n

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Manufacturing grow th rate

Price-cost margin

Gro

wth

rate

%

Source: Calculations by the author and Reserve Bank of Malawi

However, despite all these policy initiatives, the manufacturing sector registered a further significant decline in average manufacturing output growth rates during this period. Table 1 shows that the sector grew at the rate of -0.90 percent, indicating a further decline despite further liberalisation of the economy which was mainly aimed at, among other things, improving the performance of the manufacturing sector. To sum up, by looking at Figure 1, it is observed that manufacturing performance measured by price-cost margins was relatively higher during the import substitution period before dropping in the 1980s during the reforms, before rising again in the 1990s, the period associated with a significant reduction in manufacturing growth rates.

3. REVIEW OF THE LITERATURE AND HYPOTHESES

3.1 Theoretical and empirical literature

Economic theory and industrial experience suggest that structural features of an industry influence the competitive conduct of its constituent firms, the outcome of which has important consequences on resource allocation. Scarce resources are allocated most efficiently when the output of each industry is such that long-run selling price is equal to long-run marginal cost of production (Beng and Yen, 2002). In a related theoretical development, price theory has traditionally held that the degree of competition in a market is

7

related to the number and size distribution of competing firms. The smaller the number of competitors and the more skewed their size distribution, implying increased market concentration, the lower the probability that there will be aggressive competition (Adenikinju and Chete, 2002). Usually active competition exists in situations where there is more efficient allocation of resources, mostly due to the opening up of the domestic economy. Since the Cowling and Waterson’s (1976) seminar work, there has been a well-established rationale for expecting industry price-cost margins to be positively related to the level of market concentration. Theoretically trade liberalisation reduces monopolistic power and this enhances efficiency due to the reallocation of resources, which stimulates competition hence reducing prices and profits. It removes barriers to trade and altering of the incentive structure in favour of tradable goods. However, it has been argued that this enhances competition hence compel domestic firms to improve their production and management, and firms may benefit from new imported technologies and knowledge transfer, hence increase competition which may improve product quality and firm efficiency both of products and processes and provide a positive impetus to firm profitability (Kambhampati and Patikh, 2003). Thus, there is as yet, no consensus regarding the impact of reforms on the efficiency or performance of firms. Therefore, in a small open economy like Malawi, a complete specification of the structure-performance model would have to include the influence of changes in trade policies, especially international trade on domestic profitability. To some extent Kaluwa and Reid (1991) incorporated import and export extensity which captured to some extent the impact of trade policies on manufacturing sector performance in Malawi. However, their study covered the period 1969-1972, which is the period when the country practiced import substitution and trade protectionist policies. In this study we employ an analysis period of 1967-2002 which spans through three different and distinct trade regimes, making it plausible to assess to what extent the different regimes influenced the performance of the sector in terms of profitability.

The protectionist as well as import substitution strategies are theoretically envisaged to enhance inefficiency in production, as explained by the neo-classical theory which rejects protection as a viable alternative on grounds of intra-industry effects due to imperfect competition. Since barriers to entry and absence of foreign competition allow domestic producers to acquire monopoly power and enjoy supernormal profits thereby failing to achieve economic efficiency (Tybout et. al., 1991; Hossain et. al., 2004). The economic transition effects from autarky (the closed economy characterized by protectionist and import substitution policies) to the open economy is that exposure to trade induces an increase in productivity levels and average profits per firm. This process is mostly associated with the new trade theories which incorporate innovations like market imperfections, strategic behaviour and the new industrial economics, new growth theory and political economy arguments (see Jenkins (1995), Karunaratne and Bandara (2004) and Hossain et al. (2004).

The theoretical trade literature offers conflicting predictions about the evolution of firm-level performance following the trade liberalisation episode, especially in cases where imperfect competition and firm heterogeneity are taken into consideration. It has been argued that trade has both enhanced the growth opportunities of some firms while simultaneously contributing to the downfall and even exit of other firms in the same industry. On one hand, trade openness exposes domestic producers to foreign competition, reduces the firms’ market power, exploitation of economies of scale, delivers gains in productivity and efficiency, which arise from specializing according to the principle of comparative advantage for the global market, as a result firms expand output leading to reduction in average costs and increase in profitability. The production for an enlarged global market generates increasing

8

returns to scale, market share reallocations and other dynamic benefits resulting in sizeable cost reductions due to efficiency in production (Karunaratne, 2001; Pavcnik, 2002; Melitz, 2003). It is believed that domestic firms enlarge the stock of domestic knowledge as they increase their interaction with foreign markets and it is also shown that exporting activities have some learning externalities that decrease through time and increase with the level of exports (Melitz, 2003; De Hoyos et al., 2007). It has also been observed that, if foreign markets are characterized by a higher degree of competition than domestic markets, then exporters will be put under very competitive pressures than non-exporters, therefore, increasing their incentives to innovate and be more efficient in order to survive. Hence exporting firms would exhibit higher long term productivity and profitability growth than non-exporters. However, on the other hand, gains from scale economies are not very likely in developing countries like Malawi where increasing returns to scale are usually associated with import-competing industries, whose output is likely to contract as a result of intensified foreign competition, hence negatively affecting productivity levels (Tybout, 2001; Pavcnik, 2002). This has been supported by some empirical studies such as Jenkins (1995), Karunaratne and Bandara (2004) and Hossain et al. (2004), where trade openness was found to have led to an increase in technical inefficiency although theoretically a positive relationship is expected.

In models involving heterogeneous firms, international trade is found to be a catalyst for inter-firm resource reallocations within an industry, and how these reallocations affect industry performance. Since protection is reported to shelter inefficient firms, these models reveal that due to exposure to trade, firms that are less productive are forced to exit the industry, and those that are more efficient and productive, self-select themselves into the export market and become even more efficient as they get exposed to competitive pressure from foreign firms (Tybout, 2001; Melitz, 2003). This is supported by the findings of the study by Baldwin and Gu (2004), on the Canadian manufacturing sector, in which it is revealed that as trade barriers fell during the period under consideration, more Canadian plants entered the export market which led to higher productivity growth through increases in plant specialisation, learning by exporting and exposure to international competition as firms were able to exploit economies of scale and became more efficient in production. As international trade leads to faster diffusion of technology, and hence higher productivity growth, there are also the spillover effects due to ‘learning by doing’ gains and better management practices triggered by the new technology leading the firms toward the best practice technology (Krugman, 1987). To empirically assess the effects of the different arguments postulated above, a number of market structure and trade related hypotheses have been tested in explaining variations in price-cost margins in developing economies. These hypotheses are outlined in the remainder of this section.

3.2 Price mark-ups, trade and market structure hypotheses.

The role of competition and market structure in firm and industry performance has been an issue of considerable debate in both theoretical and empirical industrial economics, however, there are no doubts that variations in market structure will lead to different performance results in firms and industries. One of the most widely used indicators of market power in economic literature is the Herfindahl-Hirschman Index (HHI) of concentration in domestic production. According to oligopoly theory, the strength of mutual interdependence in price and output behaviour among competing firms depends on the number and size distribution of firms in a particular market. The higher the value of HHI, the higher the monopoly power, and the greater the probability of successful collusion (either implicit or tacit) between firms

9

assuming a large share of industry output is produced by a few firms. Since the analysis in this study is being done at firm level, HHI is emerging as a better measure of market concentration compared to other measures such as the concentration ratio which only covers a number of firms in a specific manufacturing sector, while HHI involves all the firms in an industry.

In addition to monopoly power, another dimension of market structure involves barriers to new competition. This measures the difficulty of entering an industry due to the size of the plant required for efficient operations in the industry. Theoretically, a number of issues have been identified as the main sources of barriers to entry which include economies of large scale, product differentiation and absolute capital requirements (Bain, 1951). Economies of scale pose a significant source of entry barrier if the minimum efficient scale of new entrants constitutes a substantial proportion of the industry sales, and the average cost of production increases substantially below optimal scale. Entry at optimal scale would lead to excess capacity and price war while production at below optimal scale results in high costs. Hence, the larger the minimum efficient scale for an entrant relative to the industry output, the higher the entry price. Profits and output performance can be expected to be positively related to the level of scale economy.

Another component that could also act as barrier to entry is capital intensity, since a greater percentage of capital is imported by developing countries like Malawi. The positive relationship could exist if capital-intensive firms embody the most advanced technology. However, in a developing country like Malawi where labour is the abundant factor of production, capital intensity is expected to be negatively related to output hence profitability, supporting the factor endowment theory (Kumar and Siddharthan, 1993; Chirwa, 2000). In the traditional Heckscher-Ohlin-Samuelson model based on perfect competition assumptions, it is argued that trade reflects the interaction between the characteristics of countries and their technology. The proposition that emerges is that countries will export goods whose production is intensive in the factors in which it is abundantly endowed. Capital intensity could also be negatively related to performance if it captures the levels of sunk costs which may create barriers to entry or exit. However, the differing technological characteristics of each industry mean that each industry will operate with a different ratio of capital to labour. This will affect both the rate of return on capital and the rate of return on labour.

With the Malawian development context input availability to the manufacturing process is of paramount significance in determining the performance of the industry or firm as they directly influence pricing behaviour. A principal contribution that Kaluwa and Reid (1991) brings to the analysis in developing countries is the inclusion of both output demand and input supply elasticities in the analysis. It has been argued that for a firm that is oligopolistic, the responsiveness of variations in output to variations in factor prices depends on both demand and supply of output and inputs respectively. Hence in a development context, factor scarcities should generally not be ignored. For Malawi, the study cites the relevant input scarcity variables like skilled labour, imported raw materials and working finance capital, to have a significant impact on firm’s pricing behaviour. The other characteristic that is deemed to have impact on profitability is the rate of growth of demand. In a growing market it is easier to make profits than in a stagnating one. The demand is continually shifting to the right, thus raising the equilibrium price, and it takes time for supply to increase through entry of new firms or the expansion of capacity of existing firms, however, during that time higher profits are made by existing firms in the industry. Holding other things equal, the growth of industry sales exerts a positive influence on profit. Firms in industries having a rapid increase in sales are less likely to feel competitive pressure than those in industries with stagnating

10

demand. It is argued that an industry with higher growth rate of demand will be under less pressure from competition due to higher profits encored (Yoon, 2004). In capital intensive oligopolistic industries, where overhead costs are high relative to total costs, excess capacity resulting from declining demand tends to cause a breakdown in established price discipline, leading to lower price-cost margins Beng and Yen, 2007).

In countries like Malawi, foreign producers pose the most immediate threat to entry and exert a lot of influence on the pricing behaviour of domestic firms. To the extent that actual or potential import competition keeps domestic firms from reaping monopoly profits. With low tariff rates, imports from efficient producers abroad would enter the domestic market when selling price substantially exceeds their transportation costs. It has been argued that under reasonable assumptions, a foreign entrant faces lower overall entry barriers than a domestic entrant, despite the additional tariff barriers imposed on foreign producers (assuming no import quotas). As such, foreign producers may pose the most “immediate” or potential threat to entry and exert the strongest influence on the pricing behaviour of established domestic firms. To the extent that actual import competition keeps domestic firms from reaping monopoly gains, leading to lower price-cost margins due to competition from imports. Import intensity is negatively associated with the price-cost margins especially as a result of both openness of the market and market share of imports which affect market performance as imports promote competition within the domestic market. Imported goods will naturally cause more severe competition in the domestic economy, hence negatively affecting the price-cost margin, supporting the “imports-as-market-discipline” hypothesis (Levinsohn, 1993). The hypothesis is also supported by Lopez and Lopez (2003) where imports are found to have a negative impact on price-cost margins or a disciplining effect in the US’s food processing industries in 1992. However, it is argued that an increase in imports will lead to a decrease in price and demand for the domestic good. This decrease in demand will lead to a decrease in the domestic quantity supplied. With the lower amount supplied, there is a countervailing positive effect on price and a decline in marginal costs if there are diseconomies of scale, both of which exert pressure to increase price-cost margins (see Lopez and Lopez 2003).

The existence of a competitive export market tends to compel monopolists (oligopolists) to be more competitive in pricing. A monopolist selling only in a protected domestic market will be able to set the selling price above the international price levels, however, when export opportunities exist, and if he cannot discriminate between domestic and foreign markets due to trade liberalisation, the monopolist becomes a price-taker in both domestic and world markets. In such cases price-maximisation will lead to the expansion of domestic production, hence exports resulting in the reduction of domestic prices to international levels. It is also argued that oligopolistic sellers tend to encounter greater difficulty in achieving tacit collusion with foreign sellers than with their local counterparts, largely because of differences in market environment and problems of communication. Consequently they are forced to adopt competitive pricing strategies when selling in international markets (Yoon, 2004). Exports are expected to be negatively related to the price-cost margin or performance due to either price discrimination between domestic and foreign markets or better capacity utilisation (Lopez and Lopez, 2003).

Tariff rate is employed as a policy variable to capture the level of openness or height of entry barriers faced by foreign competitors and the level of protection to local industries or the level of competitiveness the local industries are confronted with in the changing market environment. Tariff rate together with the dummy variables would help to answer the

11

question of whether liberalisation enhances the competitive atmosphere of the manufacturing sector and hence affect price-cost margins. Reduction in tariff is expected to reduce protection and expose the local firms to competition hence reduction in output and profits. However, a positive relationship between tariff rates and performance could exist especially if tariff reduction led to the importation of relevant technologies that lead to improvements in efficiency and output hence an increase in price-cost mark-ups.

4. METHODOLOGY AND DATA

To analyse the influence of market structure, and changes in trade policies on economic performance, we adopt the widely accepted theoretical approach to structure–performance modelling which follows the general classes of oligopolistic models as suggested by Kaluwa and Reid (1991), Smirlock (1985), Lloyd-Williams et al. (1994) in which an industry-level equation of the following form is suggested:

…….(1); where

where is the price-cost margin capturing the firms’ performance (see Domowitz et al. (1986)); is a measure of market concentration, is the industry elasticity of demand; while and are conjectural elasticities with respect to incumbent firms and potential entrants respectively. is a vector of factors determining conjectures amongst incumbent firms such as input factor scarcities (e.g. the availability of raw materials, skilled labour force, working finance capital and levels of technology) as they influence how firms behave towards each other in maintaining their competitiveness on the market. is a vector of variables which determine the conjectures made by incumbents about potential entrants categorised as barriers to new entry or competition. These include variables such as scale economies, and cost disadvantage ratio (CDR), while represents the policy variables. Note that due to unavailability of data and insignificant number of firms to come up with a good measure, variables such as those capturing the effect of advertising and the CDR respectively, were not included in the analysis. Therefore, based on equation (1),

; ; , and as a policy variable. Following Kaluwa and Reid (1991) model framework, the following extended econometric model specification is formulated:

…(2)

where the subscripts, and , indicate the observation for the -th firm and where is the number of firms in year , where is corresponding to the period between 1967-20027, while identifies the industry level variable. is captured by the price-cost margin, is a measure of market concentration or monopoly power, is a measure of scale economies, is the capital-labour ratio capturing capital intensity, is a measure of skilled labour, are the raw materials as a measure of barriers to entry, is the growth of demand, is export intensity, is the import intensity or competition,

is a proxy for working finance capital, are dummy variables representing the different economic policy regimes the country is envisaged to have gone through since independence in 1964, to be identified by structural breaks during analysis, while is an error.

12

is the dummy variable where for and 0 otherwise, for = the number of structural breaks over the period 1967-2002. s’ are break points to be located by grid-search following Baum (2001). The breaks are expected to capture the effects of the policy processes described in the three identified period in Section 2. To control for the changes in the general economic policy environment, many studies have used dummy variables to capture the effects of the different economic policy changes. However, it is possible to experience lags between the date a policy is announced and the date of actual implementation of the policy, as well as the adjustment by firms in terms of changing their prices, costs, investment options etc. Because of these set backs, in this paper we try to control for these lags by carrying out tests for structural breaks despite having the knowledge of when the policies were put in place in the country. This will let the data reveal the time when these policy prescriptions had effects on the manufacturing sector’s performance.

The study uses firm level panel data obtained from the questionnaire responses administered by Malawi’s NSO annually under the census of industrial production survey. This survey covers both large and medium scale profit making establishments over the period 1967-2002. Gross manufacturing output is deflated by the GDP deflator and, capital stock for each firm is estimated by the conventional perpetual inventory method and has taken into account the book value of all fixed capital assets composed of land, buildings, other constructions and land improvements, machinery and other equipment, transport equipment, gross additions and depreciation (except for land) during the year. The data set is comprised of a total of 141 firms covering the 14 four digit ISIC industries. The data relate to the period 1967-2002 and summary statistics describing the data are presented in Table 2 below. Capital was deflated by the price of capital which was approximated by the price of imports into the country, since a greater percentage of capital into the sector is imported. Export intensity and import intensity are measured at industry level because of the scarcity of data at firm level. The firm level data on imports and exports was very scanty and made it difficult to be used for the analysis, hence we used import and export data from the various publications of the Annual Statement of External Trade for various years from NSO. The data from these publications was categorized and linked to the three-digit ISIC classification used by NSO based on the Foreign Trade Classification - Malawi (1984), which establishes the relationship between the International Standard Industrial Classification (ISIC), Standard International Trade Classification (SITC) and HS codes or the Customs Co-operation Council Nomenclature (C.C.C.N.).

Table 2: Summary Statistics

Source: Malawi National Statistics Office and the Reserve Bank of Malawi

Variable Obs Mean Std. Dev. Min Maxpcm 2672 -6457.17 169357 -5331050 1.00hhi 2686 0.0928 0.1979 -0.005 1.36imp 2695 0.5389 1.3393 0.00 18.10exp 2695 0.1237 0.4597 0.00 7.80Rmtrs 2676 609173.3 5839267 -9181537 135000000Skill 2665 15901.34 42528.37 0.00 514285.7fink 2671 34.9873 490.02 0.00 18954.03Mes 2695 35.57 19.95 3.01 100.00klr 2674 125.86 1242.68 0.00 53462.76dem 2523 5997235 301000000 -100.00 15100000000tariff 2695 79.18 51.49 20.57 188.23

13

Considering the relationship that exists between price-cost margins, trade related variables, market structure and performance variables, it is worthy examining the correlation between evolution of these variables. Table 3 reports the corresponding simple correlation coefficients. The correlation results show that in terms of variables capturing the level of market concentration, there is a positive correlation between price-cost margin and the concentration ratio (hhi), while having a negative correlation with export and import intensity. In terms of factors determining conjectures amongst incumbent firms, the correlation results show that there is a negative correlation between price-cost margins (pcm) and raw materials (rmtrs), however there is a relatively high correlation between raw materials and concentration ratio, which could be indicating the level of input factor scarcities since a greater percentage of raw materials is imported. The results also show a positive correlation of 0.17 between price-cost margin and the capital-labour ratio (klr) which to some extent measures the skill level in relation to capita utilisation. Growth of demand (dem) and scales economies (mes) show a positive correlation with price-cost margins while tariff exhibits a negative correlation. It is also important to note the relatively higher and positive correlation that exists between market concentration and raw materials, between import intensity and minimum efficient scale, and between working finance capital and capital-labour ratio.

pcm hhi imp exp rmtrs skill fink mes klr dem

Hhi 0.1244Imp -0.0311 0.3167Exp -0.0372 -0.0189 -0.2196Rmtrs -0.1992 0.5796 0.0254 0.0853Skill 0.0554 0.0773 0.2374 -0.1419 0.0977Fink 0.0062 0.2277 0.2386 -0.1830 0.1524 -0.1642mes -0.0865 0.1371 0.4657 0.3608 0.1512 0.3355 0.3603Klr 0.1732 0.3319 0.1214 -0.1828 0.2953 0.3401 0.5905 0.1930Dem 0.0120 0.1172 0.0571 0.0252 0.0515 -0.0494 -0.0273 -0.0112 0.0175Tariff -0.0205 0.0092 -0.0882 -0.1588 0.1492 0.1087 0.0520 0.0147 0.1716 -0.1122

Table 3: Correlation coefficients for performance, trade and market structure variablesSource: Malawi National Statistics Office and the Reserve Bank of Malawi

5. EMPIRICAL RESULTS

Table 4 presents panel regression results on the factors affecting Malawi’s manufacturing sector performance which is captured by the price-cost margins. As indicated in the methodology section, before carrying out the regression analysis we first, following Baum (2001), carried out the Clemente-Montañés-Reyes unit-root test with double price-cost margin’s mean shifts, in order to establish the time when the sector experienced structural breaks in its performance. These breaks could be attributed to the effects of the different policy prescriptions under the different policy regimes, outlined in Section 2, could have had on the manufacturing sector’s performance. Appendix Figure 1 presents the results of these tests and they show that Malawi’s manufacturing sector performance experienced significant structural breaks in the years 1982 and 1991. From the Figure it is not surprising to note that the most significant structural breaks occurred during these periods. The break in 1982 could be related to the long-run effect of the economic instability before the country adopted the

14

structural adjustment programme strategies initiated since 1981 by the Malawi Government. This was significantly due to the worsening BOPs position of the country’s economy as a result of the global oil crisis, acute deterioration of the terms of trade and exacerbation of excess demand for imports originating from deficit financing of public expenditure, and increased external transport costs due to the civil war in Mozambique, which led to the influx of refugees into the country exacerbating the situation further. Partly these developments led to the rise of both the current account and fiscal deficit.ii The structural break identified in 1991 could have been due to the accumulation and continued effects of these SAPs strategies, in particular, Malawi being an agricultural based economy, this could have been due to the concerted effort on domestic economy liberalisation especially with respect to the liberalisation of the agricultural and the financial sectors in the late 80s and early 90s. This encompassed the liberalisation of the marketing of smallholder agricultural produce in 1987, the liberalisation of prices for agricultural produce and marketing of agricultural inputs, and also the deregulation and the phased removal of fertiliser subsidy which was completed by 1991. With reference to the financial sector, interest rates and entry into the financial sector were liberalised by 1988 and 1989 respectively (Chirwa, 2003; Chirwa and Mlachila 2004). It is also important to note that the government was implementing these financial reforms amidst a very unstable macroeconomic environment characterised by high rate of inflation largely due to structural rigidities within the economy and devaluation of the currency, large budget deficits, increased borrowing from the banking sector and BOPs instability (Chirwa, 1999). These developments are believed to have had a significant impact on the performance of the manufacturing sector since most of the industries were agricultural based, as well as through increased access to banking and financial services due to the liberalisation of the financial sector. Furthermore, entry into manufacturing was also liberalised in 1991 after completion of the phased decontrol of prices.5 These policy strategies could have had a significant contribution to the economy’s structural break identified in 1991.

Among the results in Table 4, Model 1 is based on the total sample observations 1967-2002, Model 2 is based on a subsample representing the import substitution/protectionist period (1967-1982), while Model 3 is based on the sub-sample representing the period of structural reforms (1983-1991), and Model 4 represents the post-liberalisation period (1992-2002). Despite the historical trade regimes stipulated in Section 2, these analysis periods are based on the results of the analysis above which led to the identification of the two distinct structural breaks in the manufacturing sector performance over the period under consideration. The Hausman test was used for the choice of the models and suitability of the random effects over the fixed effects model in all the models reported in Table 4. In all the four models the Hausman test led to the rejection of the null hypothesis favouring the fixed effects models as the random effects models were rejected except in Model 4. However, the diagnostic test results for Model 1 and 3 revealed the presence of first order autocorrelation (AR(1)) since we reject the hypothesis of the absence of first order autocorrelation in the models using the Wooldridge test, and also the cross-sectional data revealed the presence of panel heteroscedasticity using the Wald test. This led to the use of the Feasible Generalised Least Squares (FGLS) to estimate both models 1 and 3. The FGLS allows estimation in the presence of AR(1) autocorrelation within panels, and cross-sectional correlation and heteroskedasticity across panels to obtain consistent and efficient estimates. FGLS is deemed an efficient estimation method if time period (T) is greater than the cross-sectional units (N), which is the case in these Models as the data covers longer periods (Beck and Katy, 1995). However, models 2 and 4 revealed the presence of groupwise heteroscedasticity without the presence of first order autocorrelation, hence prompting the use of the statistical software STATA’s Robust command to obtain robust estimates.

15

Table 4: Panel Data Regression Estimates of the Structure and characteristics on Performance in Malawi’s Manufacturing Sector

Variables  Model 11967-2002FGLS

Model 21967-1982FE(Robust)

Model 31983-1991 FGLS

Model 41992-2002RE (Robust)

Hhi 0.128*** (0.000)

0.175***(0.000)

0.091***(0.000)

0.157***(0.000)

Imp -0.044*** (0.000)

-0.330***(0.000)

0.014(0.425)

-0.086**(0.021)

Exp -0.006 (0.528)

-0.064***(0.006)

0.025(0.174)

-0.055**(0.019)

Rmtrs -0.225*** (0.000)

-0.488***(0.000)

-0.186***(0.000)

-0.241***(0.000)

Skill -0.031*(0.065)

0.038(0.565)

0.019(0.644)

-0.081**(0.015)

fink -0.073*** (0.001)

-0.096*(0.106)

-0.165***(0.001)

-0.062(0.226)

Mes -0.013 (0.748)

0.090(0.525)

0.090(0.362)

0.274**(0.017)

Klr 0.129*** (0.000)

0.081*(0.100)

0.255***(0.000)

0.084**(0.029)

Dem -0.008 (0.566)

-0.008(0.750)

-0.013(0.650)

0.0001(0.997)

Tariff 0.008 (0.835)

0.058(0.314)

-0.074(0.401)

-0.198(0.144)

Dummy83-91 -0.005(0.927)

Dummy92-2002 0.154** (0.031)

Intercept 1.727*** (0.000)

2.958***(0.000)

0.924(0.183)

2.234**(0.047)

Hausman test 47.09*** (0.0000)

27.19***(0.0000)

50.19***(0.0000)

15.34(0.1202)

Wooldridge test (AR1)

6.729** (0.0109

0.652(0.4223)

3.423*(0.0693)

17.230***(0.0001)

Wald test 1.3e+05***(0.000)

1.6e+05***(0.000)

1.5e+05***(0.0000)

-

Breusch & Pagan LM test

- - - 109.46***(0.0000)

Observations 1583 678 442 463Groups 132 88 88 94

Notes: The values in parentheses are p-values and the coefficients with *** denote level of significance at 1% level; ** denote significance at 5% level; and * denoting significance at 10% level.

16

The models in Table 4 present regression results of performance measured by the price-cost-margin on variables in Equation (2). The results show that the variables related to the role market concentration plays in influencing price-cost mark-ups, , is positively associated with performance, with the coefficient of the variable being statistically significant at below 1 percent level in all the four models. This is in support of the relationship exhibited by the correlation coefficient between these variables in Table 3, and it also renders support to Bain’s (1951) hypothesis, arguing that there exists a positive correlation between market concentration and performance measured by the price-cost margin. However, the result is in contrast to the findings of Kaluwa and Reid (1991), where the concentration variable was found to be insignificant and with the wrong sign, which could be suggested to be because of the period under consideration in their study (1969-1972), which is much shorter as compared to the period in this study. Also, the period considered by Kaluwa and Reid (1996) was characterised by entry restrictions to the manufacturing sector and price controls on certain lines of products where planned price increases had to be notified to the Ministry of Trade and Industry for approval, which would only be justified by exogenous cost increases (Kaluwa, 1986), hence the insignificant impact in their results.

Import intensity is found to be negative and highly significant at conventional levels of significance in the overall model (Model 1), import substitution period (Model 2) and in the post-liberalisation period (Model 4), revealing that an increase in imports led to a reduction in price-cost margins of the domestic firms, which is in line with the findings of Kaluwa nd Reid (1991). The results are consistent with the imports-as-market-discipline hypothesis, since under the pressure of imports, it is expected that price-cost margins would decrease especially for the firms that have market power (Lopez and Lopez, 2003; Culha and Yalcin, 2005). However, there is a relatively significant reduction on the impact of import intensity on price-cost margins in the post liberalisation period as compared to that in Model 2 (the import substitution period), which could imply some improvements in the performance of the sector as the costs of production were significantly reduced. Another conjecture is that domestic firms may not be able to compete with better quality and sometimes cheaper foreign goods and may therefore experience reduction in price-cost margins as they reduce prices in order to remain competitive. As we pass from the import substitution industrialisation period to the post-liberalisation period, the significant change in the size of the coefficient of the import intensity variable shows that imports had a relatively significant impact on price-cost margins during the import substitution period.

Export intensity appears with the correct sign, with its increase leading to the lowering of price-cost margins in models 1, 2 and 4, however, it is significant at conventional levels of significance only in Models 2 and 4 supporting the findings by Kaluwa and Reid (1991). The negative sign for the coefficients is consistent with the findings of House (1973), Lopez and Lopez (2003) and Culha and Yalcin (2005), accounting for the fact that, as firms become more export oriented, they are in a better position to exploit economies of scale and operate on smaller price-cost margins. This could also be suggesting that Malawian firms to a greater extent adopted competitive pricing strategies existing on the international market hence negatively affecting their price-cost margins. Meaning that Malawian exports have not been competitive enough to have significant control or influence over prices on the international market, especially in the post-liberalisation period.

Among the variables that relate to the scarcity of factor inputs which include raw materials, that skilled labour and finance capital, raw materials are found to have a negative and highly

17

significant influence on price-cost margins at below 1 percent level of significance throughout the 4 models estimated, while having a relatively greater influence on price-cost margins during the import substitution period (Model 1). This negative impact could be attributed to the scarcity of raw material inputs most of which are imported hence leading to higher production costs (Kaluwa, 1986). Skilled labour captured by average earnings is found to be positively related to price-cost margins in Models 2 and 3 but statistically insignificant at conventional levels, however it is found to be negative but highly significant at 5 percent level in the post-liberalisation period. This could be suggesting that there might have been a lot of labour movement due to liberalisation hence leading to a reduction on wages and easing the pressure on price-cost margins for the manufacturing sector in the country. The other variable which is a proxy for the availability of working finance, is found to have a negative and significant influence on price-cost margins at conventional levels of significance in all the models except in the post-liberalisation period (Model 4). The findings are in contrast to Kaluwa and Reid (199), as they found working capital to have a positive and significant impact. This could imply the effect of the competitive financial market especially during the liberalisation period (Model 3), where the financial sector and lending rates were liberalised, hence enhancing the availability of working finance leading to a reduction in price-cost margins.

With regard to the variables representing the barriers to entry, the minimum efficient scale variable, , is positive and statistically significant at 5 percent level in Model 4. This means that, on average, economies of scale constituted a significant source of entry barriers to new entrants especially in the post-liberalisation period. To a greater extent this could imply that firms enjoyed economies of scale due to the opening up of the economy as a result of liberalisation. The coefficient of capital-labour ratio (taken as a measure of firms’ technological levels), which is a scarce resource in many manufacturing firms in the country, is found to be positive and statistically significant at conventional levels across all the models. The same result was obtained when the capital-labour ratio was replaced with the variable used in Kaluwa and Reid (1991), the capital-sales ratio, as a measure of capital intensity. This result is not in support of the results in Kaluwa and Reid (1991) and Chirwa (2004), where their results are against the factor endowment theory, where capital intensity is found to be an insignificant determinant of price-cost margins. However, in our findings, the size of the coefficient of the capital intensity variable is relatively higher during the structural reforms period with regard to its impact on price-cost margins. Since most of the capital goods are imported, liberalisation of the economy especially through devaluation of the exchange rate, led to an increase in the cost of imported capital goods for domestic firms, hence leading to an increase in the price-cost margins. To some extent this could also be supporting the notion that capital intensive firms embody the most advanced technology, and due to liberalisation of the economy the flow of technology and knowledge is enhanced, especially in Malawian firms as they would have been starved of technological flow to the country due to the protectionist regime that preceded the liberalisation of the economy. It could also be argued and suggested that due to the scarcity of skilled labour force in countries like Malawi, increase in labour absorption takes place much slower than the expansion of capital accumulation, hence leading to an increase in capital-labour ratio intensity, leading to an increase in price-cost margins.

The proxy for the rate of demand in all the models’ results appear with the expected sign only during the post liberalisation period, but insignificant at conventional levels across the models. Hence, growth in demand does not seem to play a critical role in enforcing price-cost margins during the period understudy. The only policy variable included in the analysis is

18

tariff rate. In the total sample model, tariff rates have a positive but insignificant impact on price-cost margins while it has a negative but also insignificant impact across the rest of the models, signifying the minimal influence of tariff rates on price-cost margins in the sector.

The dummy variables capturing the impact of the revealed structural breaks in the sector’s performance and representing the effects of the different policy initiatives undertaken by the Malawi Government during the identifies periods in Model 1 (dummy83-91, dummy92-2002) are found to have a negative and insignificant impact on price-cost margins over the period after 1982. However, the structural break after 1991 (Dummy92-2002) is found to have a highly significant positive impact on price-cost margins, at below 5 percent level of significance.

Comparing the models 1 with dummy variable capturing the effect of the structural breaks after 1982 to Model 3, without the dummy variable (since to some extent they are capturing the effect of policy initiatives based on almost the same period of analysis), the results show that if the dummy variables are not included, the structure-performance model may result into biased coefficients of the variables. It is observed that the coefficient of market concentration and raw materials increase from 0.09and 0.19 in Model 3 which is without the dummy variable, to 0.13 and 0.23 respectively when the dummy is included (i.e. in Model 1). Similarly the coefficients of working finance and capital-labour ration decrease from 0.17 and 0.26 respectively in Model 3 to 0.07 and 0.13 respectively when the dumy variable is included (in Model 1). However, the inclusion of the dummy variable leads import intensity and skilled labour from being insignificant without the dummy variable (in Model 3), but becomes highly significant when the dummy is included with a value of 0,04 and -0.03 respectively.

Since the structural break captured by Dummy93-2002 is associated with the period captured by Model 4, the effect of the policy strategies during this period captured by the dummy variable, led to the reduction in the size of the coefficients of the market concentration measure, import intensity, raw materials and skilled labour from 0.16, 0.09, 0.24 and 0.08 in Model 4 (without the dummy) respectively, to 0.13, 0.04, 0.23 and 0.03 in Model 1 respectively. However, the inclusion of the dummy variable led to an increase in size of the coefficient for capital-labour ratio from 0.08 in Model 4 to 0.13 in Model 1, as well as rendering export intensity and economies of scale measure insignificant. To some extent could be suggesting that some of the policy strategies implemented during the said period rendered the sector’s exports uncompetitive on the world markets, hence having no impact on domestic prices. While making financing capital significant in Model 1, despite Chirwa and Mlachila (2004) arguing that despite liberalisation of the financial sector, banks continued using their monopoly power in determining interest rates making them les favourable for the depositiors and borrowers. Form the results in Model 2 it is worth noting that the size of the coefficients for market concentration, import and export intensity, and raw materials were relatively larger compared to the size of these variables’ coefficients in the other models in Table 4. Suggesting that during this period in which trade protectionist and import substitution strategies were practiced, these variables had a relatively higher significant influence on price-cost margins.

19

6. CONCLUSIONS

The paper has tried to assess the relationship between trade policy changes, market structure and manufacturing sector performance in Malawi using firm level panel data. We have observed that policy changes and strategies led to two significant structural breaks in the manufacturing sector performance in 1982 and 1991, mainly attributed to the country’s economic crisis in the late 1970s and early 1980s, and due to the accumulation and continued effects of the SAPs strategies, in particular, the liberalisation of the agricultural and the financial sectors in the late 80s and early 90s respectively. Based on the econometric analysis we can assert with some confidence that price-cost margin increases with the degree of market concentration in an industry. In particular, it has demonstrated the relevance of industrial organisation as a tool for analysing problems associated with performance in Malawi’s manufacturing sector. The results lend support to the hypothesis that firms in a market protected from competitive pressures by high entry barriers exploit this position and earn an excessive rate of return on capital. One possible explanation is that x-efficiency that arises from the inefficient use of resources failed to outweigh the effect on profits of the excess prices charged in the monopolistic firms. We find barriers to entry created by economies of scale to be in support of this understanding especially in the post-liberalisation period while they are negative in the pre-liberalisation period.

Imports and exports are found to have a negative and significant impact on the firms’ performance in line with economic theory especially during the import substitution/protectionist and post-liberalisation periods. Despite showing this negative impact, the dummy variable capturing the economic liberalisation after 1994 is found to have a positive and significant impact on the price-cost margin, signifying some positive improvements on the price-cost margins. This could imply that opening up the economy led to improvements in the performance of the manufacturing sector as the firms became more efficient as they faced more competitive pressures. Firms were able to import capital goods and the latest technology hence increase efficiency as signified by the impact of capital-intensity, and also liberalisation increased firms access to wider markets hence taking advantage of the economies of scale to reduce costs.

My analysis has some implications on policy aimed at creating a competitive industrial environment and maximising the firm’s profits. The study has identified key structural variables that could lead to an improvement in the sector’s performance if taken into consideration by policy makers. International trade has considerable impact on domestic profitability looking at the effects of import and export intensity. Import intensity led to reduction price-cost margins due especially to competitive pressures from better quality and sometimes cheaper foreign goods due to liberalisation, leading to reduction in price-cost margins as firms reduce prices in order to remain competitive. Export intensity results have indicated that Malawian exports have not been competitive enough to have significant control or influence over prices on the international market, especially in the post-liberalisation period, leading to reductions in profitability. Policies aimed at enhancing export performance (in high quality products) in the country could be the most effective policy measures to promote more competitive market conduct. Import discipline is crucial in small domestic markets like the one in Malawi where concentration seems inevitable if excess capacity is to be avoided. Emphasis should be placed on technological transfer through importation of emerging technologies, the associated knowledge and expertise which could enhance

i The growth rate during the period is based on the author’s calculation.ii See Ahsan et. al (1999) for a detailed analysis on this issue.

20

technological innovation and hence lead to the production of high quality commodities that could be competitive hence raise profits for domestic firms on the global market. This should be accompanied by putting in place tax measures aimed at enhancing the performance of the sector especially with regard to technological imports. The effectiveness of imported technologies and the associate knowledge and skills will depend on Malawi’s existing technological capacity to acquire, assimilate and utilise these technologies. This calls for emphasis on the development of science, technology and innovation skills in the country’s education system. As stipulated in Kaluwa and Reid (1991), availability of factor inputs play a significant role in determining a firms profitability in Malawi. This calls for deliberate efforts by the government enhance the availability of factor inputs such as raw materials for manufacturing, skilled labour and financing capital for businesses, as well as increasing access to loanable funds for start-ups, choice and enhancing access to appropriate technologies. More emphasis could also be placed on mechanisms to reduce scale barriers to entry in order to enhance entry and competition in the different industries within the manufacturing sector, with greater emphasis on export promotion which would accelerate growth and also improve efficiency in the manufacturing sector.

Notes

1. See Mulaga and Weiss (1996), Chirwa (2003) and World Bank (1989) for more details on Malawi’s trade policies.

2. The growth rate is calculated for the period 1973-80 due to the unavailability of data for the other years before 1973. However, Chirwa (2003) reports a manufacturing value-added growth rate of 6.7 percent over the same period.

3. See Njolwa (1982); World Bank (1989); Mulaga and Weiss (1996); Ahsan et al. (1999).

4. See Ahsan et al. (1999) for a detailed analysis on this issue.5. See Chirwa and Zakeyo (2003).6. See Chirwa and Zakeyo (2003) for more details.7. Note that there were 141 firms in total involved in an unbalanced panel as some of the

firms could not make it into the NSO Annual Economic Survey sample due to poor performance and some gained entry to the sample as their performance improved over the years under consideration.

8. See Chirwa (2004) for more details.9. Darwin empasised the process of entry and exit of firms as they get more exposed to

international trade

REFERENCES

Adenikinju F. Adiola and Chete Louis (2002). “Productvity, market structure and trade liberalisation in Nigeria”. AERC Research Paper 126. AERC, Nairobi, Kenya.

Ahsan, A.Machinjili C. and Mkwezalamba, M.M. (1999), ‘The Impact of Adjustment Policy Reforms on Malawi’s Manufacturing Sector’, World Bank, Malawi Field Office, Lilongwe.

Bain, J. S. (1951), ‘Relation of Profit Rate to Industry Concentration: American Manufacturing 1936-1940’, Quarterly Journal of Economics, Vol. 65 No. 3: 293-324.

21

Baldwin John R. and Gu, Wulong (2004). “Trade Liberalization: Export-Market Participation, productivity growth and Innovation”. Oxford Review of Economic Policy, Vol. 20 (3), pp. 372-392.

Baum Christopher F., (2001), “Stata: The language of choice for time series analysis.” The Stata Journal, Vol. 1, No. 1, pp. 1-16.

Beck, N. and Katy, J.N. (1995), ‘What To Do (and Not To Do) with Time Series Cross-Section Data’, American Political Science Review, Vol. 89: 634-647.

Beng, Gan Wee and Yen, Tham Siew, (2007). “Market structure and price-cost margins in Malaysian manufacturing industries.” 1The Developing Economies, Vol. 15(3), pp. 280-292.

Chavula, H.K. (2010), Trade Policies and productivity in Malawi’s Manufacturing Sector: Assessing their Impact on Technical Efficiency, VDM Verlang Dr. Muller e.k.

Chirwa, E. W. (1999), “Financial Sector Reforms in Malawi: Are days of financial repression gone?.” Savings and Development, Vol. 23(3), pp. 327-352.

Chirwa, E.W. (2000), ‘Privatization and Economic Efficiency in Malawi Manufacturing: Mixed Enterprises in Oligopolistic Industries’, Dissertation, University of East Anglia.

______, (2001), ‘Privatization and Technical Efficiency: Evidence from the Manufacturing Sector in Malawi’ Working paper, Economics Department, University of Malawi

______, (2003), ‘Trade Policy and Industrialisation in Malawi: The Need for a Strategic Approach’, Working Paper, University of Malawi, Zomba.

Chirwa, E. W. and Mlachila M. (2004)., “Financial Reforms and Interest rate Spreads in the Commercial Banking System in Malawi”. IMF Staff Papers Vol. 51(1), pp. 96-122.

Chirwa, E.W. and Zakeyo, C. (2003), ‘Impact of Economic and Trade Policy Reforms on Food Security in Malawi’, Report submitted to the Food and Agricultural Organisation FAO), Lilongwe Malawi and the African Economic Research Consortium AERC, Nairobi Kenya.

Cowling, K. and Waterson, M. (1976). “Price-Cost Margins and Market Structure, Economica, Vol. 43, pp. 267-274.

Culha, Ali and Yalcin, Cihan (2005). “The determinants of Price-Cost Margins of the manufacturind firms in Turkey”. Working Paper No: 05/15. Research and Monetary Policy Department, The Central Bank of the Republic of Turkey.

Das, D.K. (2001), ‘Some Aspects of Productivity Growth and Trade in Indian Industry’, Dissertation, Dehli School of Economics, University of Delhi.

De Hoyos, R.E. and Iacovone, L. (2007), ‘Economic Performance under NAFTA: A Firm-Level Analysis of the Trade-Productivity Linkages. Development Prospects Group’, World Bank, Washington DC.

Domowitz I.,Hubbard R.G. and Petersen B.C. (1986). “Business cycles and the relationship between concentration and price-cost margins.” The RAND Journal of Economics, vol. 17, No. 1, pp. 1-17.

Hotterman Sally, E. (1973), ‘Market Structure and Economic Performance in U.K. Manufacturing Industry’, Journal of Industrial Economics Vol. 22: 119-139.

Hossain, M.A. and N.D. Karunaratne (2004), "Trade Liberalisation and Technical Efficiency: Evidence from Bangladesh manufacturing Industries", The Journal of Development Studies, Vol. 40, No. 3, pp87-114.

House William J. (1973). “Market structure and industry performance: The case of Kenya.” Oxford Economic Papers, New Series, Vol 25(3). Pp 405-419.

Jenkins, R. (1995), ‘Does Trade Liberalisation Lead to Productivity Increases? A Case Study of Bolivian Manufacturing’, Journal of International Development Vol. 7:577-597.

1

22

Kaluwa, B.M. (1986), ‘Barriers to Entry, Price Controls and Monopoly Power in Malawian Manufacturing’, Dissertation, Department of Economics, University of Edinburgh, Department of Economics, Ph.D Thesis.

Kaluwa, B.M. and Reid G.C. (1991), ‘Profitability and Price Flexibility in Manufacturing for a Developinc Country’, Journal of Industrial Economics 39(6): 689-700.

Kambhampati Uma S. and Parikh A. (2003). “Disciplining firms: The impact of trade reforms on profit margins in Indian industry”, Applied Economics, Vol. 35, pp. 461-470.

Karunaratne, N.D. (2001), "Trade Reform and Technical Efficiency in Australian Manufacturing", Paper presented at the 30th Annual Conference of Economists, The University of Western Australia, 23rd to 26th September 2001.

Karunaratne N.D. and Bandara M.W.Y. (2004), “Technical Efficiency of Sri Lanka’s Manufacturing Industries”, Sri Lanka Economic Journal, Vol. 5, No.1, pp3-36.

Krugman, P.R (1987), “Is Trade Policy Passe?”, Economic Perspectives, vol. 1, pp. 131-144.

Kumar, Nagesh and Siddharthan, N.S, (1993). “Technology, firm size and export behaviour ib developing countries: The case of Indian emtreprises”. Working Paper No.9, UNU/INTECH.

Levinsohn J. (1993). “Testing the Imports-as-Market Discilpline Hypothesis”. Journal of International Economics, Vol. 35, pp 1-22.

Lloyd-Williams, D.M., Molyneux, P. and Thornton, J. (1994), ‘Market structure and performance in Spanish banking’, Journal of Banking and Finance, Vol. 18: 433-443.

Lopez R.A. and Lopez E. (2003). “The impact of imports on price-cost margins: An empirical illustration.” Empirical Economics, vol. 28(2), pp 403-416.

Malawi Government, (1961), First Development Plans, 1961-1964, Government Printer, Zomba.

Malawi Government, (1971), Statement of Development Policies, 1971-1979, Government Printer, Zomba.

Malawi Government, (1987), Statement of Development Policies. 1971-1979, Government Printer, Zomba.

Malawi Government, (2004), Economic Report, Ministry of Economic Planning and Development. Lilongwe, Malawi.

Melitz Marc, J. (2003), ‘The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity’, Econometrica, Vol. 716: 1695-1725.

Milner, C. and Zgovu, E. (2003), ‘Export Response to Trade Liberalisation the Presence of High Trade Costs: Evidence for a Landlocked African Economy’, Centre for Research in Economic Development and International Trade, University of Nottingham, UK.

Mulaga, G. and Weiss, J. (1996), ‘Trade Policy and Manufacturing Sector Performance in Malawi, 1970-91’, World Development Vol. 24: 1267-1278.

National Statistical Office, (2006), Quarterly Statistical Bulletin (various issues). National Statistical Office (NSO): Zomba, Malawi .

Njolwa, M.M.Z. (1982), ‘Industrial Development in Malawi: Problems and Prospects for the 1980s’, Paper presented at the International Social Science conference at Chancellor College: Zomba, Malawi.

23

Pavcnik, Nina (2002). “Trade Liberalization, Exit and Productivity Improvement: Evidence from Chilean Plants”, Review of Economic Studies, Vol. 69, pp. 245-276.

Reserve Bank of Malawi, (2006), ‘Monetary Policy, Exchange Rate Management and Devaluation in Malawi – Past and Present’, Presented by Mr Victor Mbewe, Governor Reserve Bank of Malawi at the Economics Association of Malawi (ECAMA) Conference: Lilongwe, Malawi.

Smirlock, M. (1985), ‘Evidence on the (non) relationship between concentration and profitability in banking’, Journal of Money, Credit and Banking, Vol. 17: 69-83.

Tybout, J.R., et al. (1991), "The effects of trade reform on trade and technical efficiency : New evidence from Chile", Journal of International Economics, vol. 31, pp. 213-250.

World Trade Organization (WTO), (2002), Trade Policy Review, Malawi, Report by the Secretariat (2002). WTO: Geneva.

World Bank, (1981), Accelerated Development in Sub-Saharan Africa: An Agenda for Action. The World Bank: Washington DC.

World Bank, (1989), Malawi Industrial Sector Memorandum. The World Bank: Washington D.C.

World Bank, (2002), The Impact of Trade Policy Reforms on Malawi’s manufacturing sector. The World Bank: Washington DC.

Yoon, Seok, (2004), ‘A note on the market structure and performance in Korean manufacturing industries’, Journal of Policy Modelling, Vol. 26: 733-746.

APPENDIX:

24

Appendix Figure 1: Clemente-Montañés-Reyes unit-root test with double price-cost margin’s mean shifts, AO model

Appendix Table 1: Variable Definitions

Variables Description Definitionspcm Price-cost

marginThe ratio of the difference between value added and payroll to total sales.

hhi Herfindahl-Hirschman Index (HHI)

The measure of concentration in domestic production measured at the four digit international standard industrial classification (ISIC) level.

imp Import intensity

value of imports to total industry sales ratio

exp Export intensity

value of exports to total industry sales ratio

skill Skill level Average earnings

25

-2.5

-2-1

.5-1

-.5lp

cm

1970 1980 1990 2000Year

Test on lpcm: breaks at 1982,1991

-1-.5

0.5

11.

5D

.lpcm

1970 1980 1990 2000Year

D.lpcm

Clemente-Montañés-Reyes double AO test for unit root

Optimal breakpoints : 1982 , 1991

AR( 1) du1 du2 (rho - 1) constCoefficients: -0.27724 0.40382 -1.07667 -0.85374t-statistics: -2.198 2.968 -5.512P-values: 0.036 0.006 -5.490 (5% crit. value)Note: lpcm is the log of the price-cost margin

klr Capital-labour ratio

Obtained by dividing capital by labour. Labour refers to the number of persons engaged in each firm, which includes the workers directly involved in the production process.

mes Minimum efficient scale

Average employment of firms accounting for 50% of total industry employment as a percentage of total industry employment

fink Working finance capital

Product of the estimated minimum efficient scale and the ratio of capital (net book value of fixed assets) to industry output.

rmtrs Raw materials

Total cost of raw materials deflated by the GDP deflator.

dem Demand Percentage change in salestariff Import tariff

rateCalculated by dividing total import duties by the volume of imports

26