DEMAND SYSTEM ANALYSIS OF THE SOUTH KOREAN BEEF MARKET WITH THE FREE TRADE DEMAND MODEL YOUNGJAE LEE P. LYNN KENNEDY

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1 DEMAND SYSTEM ANALYSIS OF THE SOUTH KOREAN BEEF MARKET WITH THE FREE TRADE DEMAND MODEL YOUNGJAE LEE Deartment of Agrcultural Economcs and Agrusness Lousana State Unversty AgCenter 101 Agrcultural Admnstraton Buldng Baton Rouge LA Phone: Fax: E-mal: P. LYNN KENNEDY Deartment of Agrcultural Economcs and Agrusness Lousana State Unversty AgCenter 101 Agrcultural Admnstraton Buldng Baton Rouge LA Phone: Fax: E-mal: Selected Paer reared for resentaton at the Southern Agrcultural Economcs Assocaton Annual Meetng Dallars TX Feruary Coyrght 008 y Youngae Lee and P. Lynn Kennedy. All rghts reserved. Readers may mae veratm coes of ths document for non-commercal uroses y any means rovded that ths coyrght notce aears on all such coe

2 Demand System Analyss of the South Korean Beef Maret wth the Free Trade Demand Model Astract In ths study a demand system analyss for eef n South Korea s constructed. A free trade demand system was used n whch the economc welfare of maret artcants are maxmzed. Recognzng mlct dscrmnaton aout non-locally sourced eef roducts ths study deduces maret demand euatons wth resect to consumer reference n order to dentfy the margnal effect of change consumer reference has on maret demand. Introducton Neoclasscal endowment models show that rce dfferences etween mortng and exortng regons rovde oortuntes to ncrease economc welfare through trade (Samuelson 1948; Bhagwat 1964). For mortng artes most trade enefts accrue to consumers as local consumers have ncreased choce wth trade. In contrast local roducers face a more comettve maret wth a lower rce than efore the nsttuton of trade leralzaton. Accordng to the eualzaton of factor rces rces etween mortng and exortng regons wll gradually converge nto one rce wth ncreased maret access where the economc welfare of oth artes s maxmzed. However a rce dfference etween local and morted roducts does exst n oen marets. For examle rce dfferences etween locally roduced eef and morted eef currently exst and have contnued to grow after South Korea oened ther eef maret to the world economy n 001. These rce dfferences n the oen maret may reflect consumer reference for locally roduced eef. However the ncreasng trend of rce dfferences seems to e unexected n lght of ratonal consumer ehavor and enforced rce cometton derved from trade theory. In fact t s true that consumer reference can e dstorted y non-economc factors such as merfect nformaton and/or mlct dscrmnaton le natonalstc uy domestc roduct camagns. Once tastes have een estalshed consumers ersst n mang urchasng decson 1

3 followng the estalshed reference and reure a long tme to recover from these dstorted references. Therefore these references can contrute to the reason for the exstence of a large rce dfference etween locally roduced eef and morted eef n South Korea and why ths dfference n rce contnues to ncrease followng the leralzaton of the South Korean eef maret. In 005 the rce of morted eef was $4.68 er logram n the South Korean eef maret whle consumer rce of locally roduced eef was $36.11 er logram (exchange rate s 1034 Korean Won/$1 005) ths s a 770% rce dfference n 005 as comared to only 190% n 001. Furthermore concerns exst as to merfect nformaton related to food safety ecause of the occurrence of Bovne Songform Encehaloathy (BSE or mad cow dsease ) n the Unted States n 003 caused South Korea to totally dscontnue U.S. eef morts untl 007 when the U.S. and South Korea sgned a Free Trade Agreement (FTA). Followng the estalshment of a FTA etween the Unted States and South Korea some agrcultural economsts and some olcy maers redcted a rosy rosect for U.S. eef roducers ecause the FTA would eventually elmnate the hgh tarffs on U.S. eef allowng U.S. eef to to e more comettve rcewse n the South Korean eef maret relatve to the eef suled y other countres. However even though the South Korean eef maret has een oen snce 001 U.S. eef roducers have not enefted from ncreased maret access. In contrast the scare resultng from BSE restrcted U.S. eef from the South Korean maret. It s ratonal to thn that rce advantages for U.S. eef resultng from a FTA would result n ncreased cometton n the South Korean eef maret. However the consumton ehavor of the South Korean eef consumer would aear to e not totally deendent uon rce consderatons. Ths study s conducted to analyze consumer ehavor n the South Korean eef maret. In dong ths ths study wll llustrate the effects of consumer reference on maret demand. Ths study roceeds as follows: In the next secton a free trade demand system (FTDS) wll e ntroduced wth emrcal estmaton of the South Korean eef maret. In

4 secton three the role of consumer reference n the FTDS model wll e dscussed. In secton four a concluson and ref suggestons for the South Korean eef maret strategy wll e rovded. Free Trade Demand System The fve maor source-dfferentated eef sulers n the South Korean eef maret are South Korea (SK) the Unted States (US) Australa (AU) Canada (CA) and New Zealand (NZ). As Sarrs and Freearn (1983) llustrated y way of a oltcal reference functon (PPF) aroach under non-free trade olcy of an mortng country a free trade demand system smly egns wth followng lnear demand euaton: (1) = A B = where we assume that A and B are uncondtonal coeffcents whch can e reverted to nverse maret rce euaton (see Houc (1965 and 1966) Huang (1994 and 1996) and Eales (1996) for more nformaton regardng elastctes and flexltes) as follows: () = a = where A a = and B 1 =. Later n the course of ths study ths uncondtonal B assumton wll e tested usng emrcal data. Gven the nverse maret rce the welfare gan of the South Korean eef consumer euates to the followng: a 1 (3) CS =. Smlarly the sum of welfare gan of each suler euates to the followng: (4) PS ( c ) = where c s the average unt cost of eef ncludng roducton cost transortaton cost 3

5 and tarffs. Snce maret eulrum for oth rce and uantty s a result of a maret mechansm rather than governmental nterventon under a free trade olcy scenaro economc welfare of maret artcants s the summaton of the welfare gan of oth consumer and suler and s exressed as: (5) EWF = + ( c ) a 1 The economc welfare functon defned n (5) can e rewrtten n order to derve more easly a free trade demand system (the ntent of ths study) as follows: (6) EWF = α 0 + α1 + α Q + α 3 + c. where Q = s the sum of eef suled to the South Korean maret. As mled n (6) the free trade demand system s derved from the maxmzng condton of (6). In order to defne the maxmzng condton of (6) we dfferentate EWF wth resect to the fve ndvdual eef rces. EWF (7) = α 1 + α Q + α 3 + = 0. Then we otan the FTDS whch maxmzes the economc welfare of artcants n the South Korean eef maret as follows: (8) = α 1 + α Q + α 3 = where α reresents the margnal effect of maret sze on the eef comng from country and α reresents own rce effect ( = ) and cross rce effect ( ) on the eef. 3 Furthermore the arameterc relatonsh etween (3) and (8) can e defned as followng: 4

6 (9.1) a = a α 1 (9.) α = and (9.3) 3 = δ ' δ = α where δ '= 1 when and otherwse 0 and δ = 1 when = and otherwse 0. To e consstent wth the maxmzaton hyothess of EWF the second-order condtons of EWF reure that the Hessan matrx e negatve sem-defnte at the otmal condtons. Ths condton s exressed as. The Hessan matrx [ α ] 3 = should also exht symmetry. Estmaton of FTDS Conventonal demand system analyses of meat consumton data have generally used aggregate annual uarterly or monthly tme seres data of urchases and rces at the retal level (Knnucan et al. 1997; Mttelhammer et al. 1996; McGur et al. 1995). The data used n ths study consst of monthly tme seres oservatons from January 1995 to Decemer 004. Ths tme erod was urosely selected ecause 1) sgnfcant rogress of leralzaton was made n South Korea durng ths erod ) South Korean eef morts were a lttle dfferent from the scheduled level of mort commtment reflectng economc nstalty and consumer confdence for consumton of eef durng ths erod and 3) U.S. eef morts were actually anned after 005 due to a case of mad cow dsease n the 5

7 Unted States. Related to leralzaton of South Korean eef maret 1) a SBS system commenced at the egnnng of 1995 and ) on January 001 eef ecame freely mortale at a 41. ercent tarff wthout any maru ayments. South Korean eef retal rce data are otaned from the monthly consumer rce ndex announced y the Korean Statstcal Informaton Servce. The study used the Decemer 004 nomnal rce as a reference rce to transform the ndex nto a normalzed rce. Because retal-level rces for morted eef were not avalale morted eef rces were otaned from addng tarff and maru ayments to unt value mort rces. The unt value mort rces are otaned from the Korean Customs Servces. Prce data were then converted from South Korean currency the Won nto U.S. dollars y usng monthly average exchange rate data avalale from the Federal Reserve Ban of New Yor. South Korean eef consumton data was reorted at the wholesale level and was otaned from Nonghyu. Data on mort uantty were collected from the Korean Customs Servces. The summary of samle statstcs rce and uantty for each source-dfferentated category of eef s resented n Tale 1. In estmatng the arameters of the FTDS model the model had mosed uon t oth homogenety and symmetry condtons. Snce the free trade demand system s comosed of uantty share euatons for the fve source-dfferentated categores of eef would nduce sngularty one euaton was droed. The coeffcents of the droed euaton were then calculated from the addng-u restrcton. Dummy varales reflectng seasonalty n eef demand were ncluded n the re-test estmaton. Although some varales were sgnfcant they were not ncluded n the fnal verson of the model ecause of the relatvely small samle sze and ecause of the suseuent rolem related to 6

8 degrees of freedom. The FTDS model dentfes the effects of own and cross rce and maret sze on maret demand of each source-dfferentated eef at the ont of maxmzng economc welfare for maret artcants. Tale shows the margnal coeffcents of varales of rce and maret sze. Among 0 varales 17 are sgnfcant at least at the conventonal level of sgnfcance. System measure of ft s reorted n the tale elow. The negatvty condton was satsfed. For ease of nterretaton ths study converts margnal values nto elastctes. Tale 3 resents estmated own and cross-rce elastctes and maret sze elastcty at the mean of the resectve varales. As exected all own rce elastctes are negatve. New Zealand eef s most senstve to own rce whle South Korean and Australan eef are nsenstve to own rce. For South Korean and New Zealand eef four source-dfferentated eef roducts are shown to e susttutes. For US eef South Korean and New Zealand eef are susttutes whle Australan and Canadan eef are comlementary goods. In artcular U.S. eef s shown to e strongly susttutale for South Korean eef. For Australan eef South Korean and New Zealand eef are susttutes whle U.S and Canadan eef are comlements. For Canadan eef South Korean and New Zealand eef are susttutes whle U.S. and Australan eef are comlements. Related to growng maret sze ths study shows that for a 1% ncrease n South Korean eef maret sze South Korean eef consumton ncreases y 0.468% US eef 1.319% Australan eef 0.568% Canadan eef 1.688% and New Zealand eef 1.76% ncreased resectvely. Ths study also shows that f U.S. eef rce decreases as a result of the free trade agreement etween the U.S. and South Korea (elmnatng hgh 7

9 tarffs on U.S. eef) the U.S. and South Korea free trade agreement wll rng ostve exectatons for U.S. Australan and Canadan eef exorts whle South Korean and New Zealand eef sules are shown to e reduced. Role of Consumer Preference n the Free Trade Demand System If South Korean eef consumers have dfferent references for each category of sourcedfferentated eef these dfferent references wll affect maret demand for each source - dfferentated eef as follows: (10) = = ( a ) π where reresents a reference for each source-dfferentated eef and π reresents actual maret rce weghted y the reference. Wth dfferent consumer references for each category of source-dfferentated eef welfare gans to oth consumer and suler and of the gans n economc welfare of maret artcants are redefned as followng: a 1 (11) CS = π π (1) PS = (π c ) a 1 (13) EWF = π + π ( π c ) where CS PS and EWF are defned n terms of actual maret rce π rather than true rce. Fnally the reference weghted free trade demand system and arameters are redefned as followng: (14) = β1 + β Q + β 3 π =

10 9 (15) = a a β 1 (16) β = and (17) = = 3 ' δ δ β where the Hessan matrx [ ] 3 β also exhts oth symmetry and negatvty. Now to measure uanttatvely these own and cross reference macts on maret demand euaton (14) can e dfferentated wth resect to and. Then as a result own reference and cross reference dfferental euatons are defned as follows: (18) Q A π π = (19) Q B π π π + =. where + = a a A ) ( and = a B. To e consstent wth reference theory the own (cross) reference frst dervatve should e greater (less) than zero. However oth (18) and (19) are amguous as to how to determne the emrcal sgn of the frst dervatves of oth and ecause f one of the references s extremely low own (cross) reference effect wll e negatve (ostve). Even though oth (18) and (19) cannot show gloally the clear mact of reference on

11 maret demand oth euatons can e used to locally determne the emrcal mact of reference on maret demand y normalzng reference and y usng arameters estmated y econometrc method â and ˆ. Snce we now actual maret rce and uantty of maret consumton for each category of source-dfferentated eef we can determne the sgn of own reference and cross reference n those euatons wth arameter estmates â and ˆ. Euaton (18) and (19) can also e used to comare reference macts on maret demand n a varety of maret szes and maret rces wth euaton (14). Smulaton Results In order to smulate the South Korean eef model ths study estmated arameters â and ˆ usng the same data set used n the revous secton. Tale 4 shows the statstcal nformaton of â and ˆ all of whch are statstcally sgnfcant at the 1% level. The statstcs show that the sgn of eef rces of South Korea U.S. Canada and New Zealand are negatve as we exected whle the eef rce of Australa s ostve. After arameter estmaton ths study relaced a and n (18) and (19) wth that of â and ˆ to confrm emrcal sgn of change n consumer reference. Tale 5 shows the macts of changes n consumer references. The sgn of euaton (18) whch reresents own reference effect n emrcal analyss s shown to e ostve for South Korean U.S. and New Zealand eef whle the emrcal sgn of (18) s shown to e negatve for Australan and Canadan eef. Related to cross reference effect the emrcal sgn of euaton (19) s shown to e dfferent deendng on whch reference s changed. Increases n reference for South Korean eef has a negatve mact on U.S. and New Zealand eef demand. Increases n reference for U.S Canadan and New 10

12 Zealand eef decrease South Korean eef demand whle ncreases n reference for Australan eef smultaneously ncrease South Korean and U.S. eef demand. Concluson Recognzng the osslty of dstorton for consumer reference for foregn sourced eef n the South Korean maret ths study develoed a free trade demand model to analyze South Korean eef consumer ehavor. Ths research oectve was acheved n two dfferent stes. In the frst ste ths study dentfed the maxmum condton of the economc welfare functon n whch maret artcants maxmze ther economc eneft from trade hence dervng a free trade demand system wthout consderng exstng South Korean eef consumer reference. In the second ste ths study analyzed reference effects on maret demand of each category of source-dfferentated eef usng the free trade demand model weghted wth consumer reference. In undertang these efforts ths study met serous statstcal rolems n erformng emrcal estmaton under the FTDS framewor. In order to solve the rolems of ased and nconsstent estmators n the resence of mssecfcaton errors and mantan economc consstency of FTDS ths study re-secfed the model y the undertang the followng 1) elmnatng extreme outlers ) artrarly resortng the data and 3) usng a weghted regresson. Followng these recommendatons assures statstcal valdty of the FTDS model. The emrcal results of the FTDS model showed that South Korean eef consumers are shown to e negatve ut not senstve to change n own rce of each category of source-dfferentated eef excet for New Zealand eef. For South Korean eef 11

13 all four foregn eef sources are shown to e susttutes. In artcular U.S eef s shown to e the strongest susttutale good for South Korean eef. Wth ncreasng maret sze Canadan eef and U.S. eef can easly extend ther South Korean maret share relatve to other foregn sources for eef. Related to the role of consumer reference the results showed that U.S. eef can extend ther maret share wth ncreasng South Korean eef consumer reference for U.S. eef. In artcular ths result mght reflect the decrease of U.S. eef consumton after 003 when mad cow dsease was reorted n the U.S. The most nterestng fndng related to reference analyss s that an ncrease n the rces of foregn sourced eef does not negatvely affect maret demand for ths foregn sourced eef f reference for foregn sourced eef and/or maret sze ncreases and a decrease n South Korean eef rce s shown not to affect maret demand for foregn sourced eef. As a result ths study suggests that maretng strategy should e focused on ncreasng consumer reference for the U.S. eef y rovdng correct nformaton aout the roduct and on reducng dstorton of reference n order to fully succeed n the South Korean eef maret. 1

14 Tale 1. Summary Statstcs for Source-Dfferentated Beef Mean SD Mnmum Maxmum s us au ca nz s us au ca nz Sources: Korea Customs Servce and Nonghyu : South Korean Beef Consumton s us au ca nz s : U.S. Beef Consumton : Australan Beef Consumton : Canadan Beef Consumton : New Zealand Beef Consumton : South Korean Beef Prce : U.S. Beef Prce us au ca nz : Australan Beef Prce : Canadan Beef Prce : New Zealand Beef Prce 13

15 Tale. Estmated Margnal Coeffcents of Prces n Free Trade Demand System ˆα Qˆ s ˆα 3s ˆα ˆ 3us α 3au ˆα 3ca 3nz -697 *** 353 *** 17 *** *** 0.58 *** *** -66 ** *** 0.50 *** us *** 1356 *** 0.04 ** au -98 * 571 *** 0.07 *** ca *** *** nz System Weghted R = 0.99 α s an estmated margnal coeffcent of rce of eef sourced from country. ˆ3 Qˆ s an estmated margnal coeffcent of total uantty suled nto South Korean eef maret. * ndcates sgnfcance at 1% level ** ndcates sgnfcance at 5% level *** ndcates sgnfcance at 10% level 14

16 Tale 3. Prce and Quantty Elastctes at Mean Values s s us au ca nz Q us au ca nz s rce of eef sourced from country. Q s total uantty of eef suled nto South Korean eef maret. 15

17 Tale 4. Statstcal Informaton of Estmated Parameters â and ˆ. â S.E. t-value ˆ S.E. t-value s * * * * us * * au * * ca nz.3874 * * In order to estmate arameters ths study used system euaton model ecause error terms are smultaneously correlated at tme t. * reresents statstcal sgnfcance at 1% level. 16

18 Tale 5. Imacts of changes n consumer reference on source-dfferentated eef demand ˆ s ˆ us ˆ au ˆ ca ˆ nz s us au ca nz ˆ s consumer reference for eef sourced from country 17

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