Dumping and Price Distortion
Dumping is an international price discrimination in which an exporter firm sells a portion of its output in a foreign market at a very low price and the remaining output at a high price in the home market Haberler defines dumping as: “The sale of goods abroad at a price which is lower than the selling price of the same goods at the same time and in the same circumstances at home, taking account of differences in transport costs” Viner’s definition is simple.
According to him, “Dumping is price discrimination between two markets in which the monopolist sells a portion of his produced product at a low price and the remaining part at a high price in the domestic market.” Besides, Viner explains two other types of dumping. One, reverse dumping in which the foreign price is higher than the domestic price.
This is done to turn out foreign competitors from the domestic market. When the product is sold at a price lower than the cost of production in the domestic market, it is called reverse dumping Two when there is no consumption of the commodity in the domestic market and it is sold in two different foreign market, out of which one market is charged a high price and the other market a low price. But in practice, dumping means selling of the product at a high price in the domestic market and a low price in the foreign market. We shall explain price determination under dumping in this sense.
Types of Dumping
- Sporadic or Intermittent Dumping
It is adopted under exceptional or unforeseen circumstances when the domestic production of the commodity is more than the target or there are unsold stocks of the commodity even after sales. In such a situation, the producer sells the unsold stocks at a low price in the foreign market without reducing the domestic price.
This is possible only if the foreign demand for his commodity is elastic and the producer is a monopolist in the domestic market. His aim may be to identify his commodity in a new market or to establish himself in a foreign market to drive out a competitor from a foreign market. In this type of dumping, the producer sells his commodity in a foreign country at a price which covers his variable costs and some current fixed costs m order to reduce his loss.
- Persistent Dumping
When a monopolist continuously sells a portion of his commodity at a high price in the domestic market and the remaining output at a low price in the foreign market, it is called persistent dumping. This is possible only if the domestic demand for that commodity is less elastic and the foreign demand is highly elastic. When costs fall continuously along with increasing production, the producer does not lower the price of the product more in the domestic market because the home demand is less elastic.
However, he keeps a low price in the foreign market because the demand is highly elastic there. Thus, he earns more profit by selling more quantity of the commodity in the foreign market. As a result, the domestic consumers also benefit from it because the price they are required to pay is less than in the absence of dumping.
- Predatory Dumping
The predatory dumping is one in which a monopolist firm sells its commodity at a very low price or at a loss in the foreign market in order to drive out some competitors. But when the competition ends, it raises the price of the commodity m the foreign market. Thus, the firm covers loss and if the demand in the foreign market is less elastic, its profit may be more.
Objectives of Dumping
The main objectives of dumping are as follows:
(i) To Find a Place in the Foreign Market
A monopolist resorts to dumping in order to find a place or to continue himself in the foreign market. Due to perfect competition in the foreign market he lowers the price of his commodity in comparison to the other competitors so that the demand for his commonly may increase. For this, he often sells his commodity by incurring loss in the foreign market.
(ii) To Sell Surplus Commodity
When there is excessive production of a monopolist’s commodity and he is not able to sell in the domestic market, he wants to sell the surplus at a very low price in the foreign market. But it happens occasionally.
(iii) Expansion of Industry
A monopolist also resorts to dumping for the expansion of his industry. When he expands it, he receives both internal and external economies which lead to the application of the law of increasing returns. Consequently, the cost of production of his commodity is reduced and by selling more quantity of his commodity at a lower price in the foreign market, he earns larger profit.
(iv) New Trade Relations
The monopolist practices dumping in order to develop new trade relations abroad. For this, he sells his commodity at a low price in the foreign market, thereby establishing new market relations with those countries. As a result, the monopolist increases his production, lowers his costs and earns more profit.
Price distortions are defined as deviations of quoted prices from a level that would clear the market if all participants were trading for conventional risk-return optimization. In short, they measure gaps between mark-to-market prices and a plausible range of economic values of a contract. The occurrence of distortions implies that market prices can deviate from fundamental value and evidently so.
Like information inefficiency, price distortions lead to a mispricing of financial contracts relative to their fundamental value. Unlike information inefficiency, this mispricing is not based on ignorance, but on ”inefficient flows”. These are transactions in financial markets that are motivated by objectives other than return optimization. In practice, one can observe many market flows and transactions that obstruct the alignment of price and value. Common causes or triggers for such “inefficient flows” include:
- Formal and rigid risk management rules across that apply to many institutions,
- Liquidity shocks, i.e. a sudden deterioration of the tradability of assets or the risk thereof,
- Mechanical allocation rules, for example of exchange-traded funds, indexed fund and related structured products, and
- Government intervention and regulation.
Detecting price distortions
Unlike information-based trading, price distortion-based strategies do not require information advantage in respect to the traded contract. They do not focus on in-depth research of its expected value. Instead, these strategies ascertain some apparent price-value gap and market inefficiency. They subsequently use advantages in market access or in pricing know-how to extract value. Sometimes, trading speed and financial leverage can be of the essence.
Detecting inefficient flows and related distortions is not trivial. Most of what is commonly called “market noise” is actually rational trading disguised by complexity. This makes it easy to underestimate markets. However, price distortions frequently do arise pursuant to major information or price shocks that create a state of confusion or even panic. Moreover, trading in times of turmoil often bears high transaction cost, which deters market participants from immediately taking advantage of price-value gaps. In order to detect price distortions systematically one can take three different angles:
- The first is to understand and identify the causes of distortions, such as institutional risk management constraints, market liquidity problems and so forth, which are explained in the sections below. If a market is being heavily influenced by any of these causes it is more probable that prices will be regularly distorted and that there will be payback subsequently.
- The second angle are metrics of misalignment between prices and fundamental value, such as in financial bubbles. Diagnosing price distortions this way is not the same as estimating price-value gaps, as the latter would require superior information efficiency. Price distortions can be detected by conventional valuation metrics but with a focus on extreme price value gaps that associated with obstacles to arbitrage or trading.
- The third approach is to investigate the time series pattern of asset prices. For example, higher-than-exponential asset price growth with apparent feedback loops is often an indication of an unsustainable asset price bubbles. Also, temporary mild explosiveness in asset prices or exchange rates in conjunction with relative stability in underlying fundamentals is usually indicative of short-term distortions. Generally, a self-reinforcing price dynamics that is not a reflection or cause of underlying value changes is prone to producing price distortions.