BUSI 620 Week 7 Research or Interview Paper Example

Pricing Through a Strong Dollar: Exchange Rate Pass-Through and Export Pricing for a U.S. Sawmill Equipment Maker

Introduction

When the U.S. dollar strengthens, American exporters face a pricing decision that most domestic sellers never confront. A machine that sold for $40,000 in Germany now costs a German buyer more euros, even though nothing about the machine or the factory has changed. The exporter can keep its dollar price and let the euro price rise, cut its dollar price to keep the euro price steady or do something in between. Economists call the share of a currency movement that reaches the foreign price exchange rate pass-through. This paper examines how much a small U.S. manufacturer should pass through, using the pricing tools of managerial economics, published research on pass-through and a simple model of the firm's European demand.

The question matters because the answer is rarely obvious. Passing the full movement through protects the firm's margin per unit but can cost sales to local competitors. Absorbing it protects sales but shrinks the margin on every unit. Baye and Prince (2017) show that the profit-maximizing price depends on marginal cost and on the elasticity of demand, and both of those change, in the buyer's currency, when the exchange rate moves. The task is to find the price that maximizes profit after the change, not the one that preserves either the old margin or the old volume.

The Firm and the Decision

Blue Ridge Mill Works is a composite manufacturer of portable band sawmills in southwest Virginia, with about 140 employees and annual sales of roughly $42 million. About a third of its sales are exports: $8 million to Europe, mostly Germany, Austria and the Nordic countries, and $6 million to Canada. Its standard European model sells for $40,000 at the factory, and its marginal cost, mostly steel, engines, hydraulics and labor, is about $26,000 per unit. The firm invoices every customer in U.S. dollars, so a European dealer pays whatever the dollar price converts to on the day of the order.

With the euro worth $1.10, the dollar price of $40,000 equals about EUR 36,364, and the firm sells about 200 units a year in Europe. Suppose the euro then falls to $1.00, a dollar appreciation of 10 percent. Under current practice, the euro price rises to EUR 40,000. The firm's European dealers compete with sawmills built in Europe and priced in euros, so the managers worry that volume will fall sharply. They want to know whether to change their price, their invoicing currency or both.

Pass-Through in Theory

Baye and Prince (2017) derive a simple pricing rule for a firm with market power: the profit-maximizing price equals marginal cost multiplied by E/(1 + E), where E is the price elasticity of demand. With an elasticity of about -2.86, that markup factor is about 1.54, which matches Blue Ridge's ratio of $40,000 to $26,000. The rule makes the firm's price a markup over marginal cost, measured in the currency in which the buyer pays.

In euro terms, a dollar appreciation raises Blue Ridge's marginal cost. A unit that costs $26,000 to build cost EUR 23,636 at $1.10 per euro and EUR 26,000 at $1.00. If the elasticity of European demand stayed constant at every price, the markup rule would keep the same markup over the higher euro cost, and the euro price would rise by the full 10 percent: complete pass-through. Partial pass-through occurs when demand becomes more elastic as the price rises, so the firm optimally shrinks its markup as its euro cost rises. That is likely when local competitors set the market price, because each step above their prices sends more buyers to them.

The currency in which the firm invoices also shapes what happens in the short run. A firm that prices in dollars, as Blue Ridge does, passes the full movement through automatically until it changes its price list. A firm that prices in the buyer's currency passes nothing through until it revises prices. Which arrangement a firm chooses is itself an economic decision.

What the Evidence Shows

Four studies help answer the firm's question. Campa and Goldberg (2005) examined import prices in 23 OECD countries and found compelling evidence of partial pass-through in the short run, especially for manufactured goods, with producer-currency pricing more common over the long run. In other words, exporters of manufactured goods typically absorb part of a currency movement at first and pass more of it through as time goes on.

Gopinath et al. (2010) used data on the currency and prices of goods imported into the United States and found a large difference depending on invoicing currency. Even among prices that changed, average pass-through was about 25 percent for goods priced in dollars and about 95 percent for goods priced in other currencies. They showed that firms choose their invoicing currency in a way consistent with how much pass-through they want, rather than treating the currency as given. The lesson for Blue Ridge is that its dollar invoicing is a choice that sets its default pass-through at 100 percent.

Amiti et al. (2014) studied Belgian manufacturers and found that small firms that did not import inputs passed exchange rate changes through almost completely, while large exporters that imported many inputs had pass-through of around 50 percent. Their explanation had two parts that contributed about equally: imported inputs meant that a currency change moved the firm's costs as well as its prices, and large market shares let firms adjust their markups. Blue Ridge buys almost all its inputs in dollars, so it lacks the first channel, but it could create one.

Berman et al. (2012) used French firm-level export data and found that high-performance firms responded to a currency depreciation by raising their markups significantly more, and their export volumes less, than other firms. Their results are consistent with models in which demand is less elastic for stronger firms, which are therefore better able to absorb currency movements in their margins. For Blue Ridge, the implication is that its willingness and ability to absorb part of a dollar appreciation depends on how distinctive its product is in European eyes.

Across four countries' data, the pattern is the same: firms with something to protect in a foreign market absorb part of a currency shock rather than passing it all on.

Applying the Evidence: A Pricing Model for Europe

To estimate what partial pass-through is worth to Blue Ridge, I calibrated a linear demand curve to its European sales. Linear demand is a reasonable approximation when local competitors set reference prices, because it implies that demand becomes more elastic as the firm's price rises. Assuming the current price of EUR 36,364 is profit-maximizing at the current marginal cost of EUR 23,636, the curve consistent with sales of 200 units has an elasticity of -2.86 at that point, the same elasticity the markup rule implies. Under linear demand and constant marginal cost, the textbook's condition that marginal revenue equal marginal cost implies that the firm passes through half of any change in its marginal cost, a useful benchmark.

The table compares three responses to a fall in the euro from $1.10 to $1.00, which raises marginal cost in euros to EUR 26,000.

The optimal euro price, EUR 37,545, rises by about 3.2 percent, half of the EUR 2,364 increase in marginal cost in euros, and it yields the highest contribution of the three options. The firm loses about 19 units rather than 57 under full pass-through, and it earns about $11,500 per unit rather than about $10,400 under zero pass-through. No response restores the original $2.8 million contribution; a stronger dollar makes the firm's European business less profitable, and pricing can only limit the damage. The model shows how that damage is minimized.

The difference between the best and worst options, about $95,000 a year, is modest relative to total sales but large relative to the firm's export profits, and it compounds if the dollar stays strong for several years, as it often does. The model also shows why the firm's current practice is the worst of the three: dollar invoicing quietly imposes full pass-through, which is optimal only if European demand is far less sensitive to price than the firm's managers believe.

Invoicing Currency and Hedging

The pricing result has practical consequences for how Blue Ridge invoices. If the firm wants to pass through about half of currency movements, a euro price list revised periodically would serve it better than dollar invoicing. Euro pricing would give dealers stable prices, which they value when they quote to sawmill operators months in advance, and the firm would adjust the list at set intervals, for example each quarter, by about half of the cumulative currency change.

Euro invoicing shifts currency risk to Blue Ridge, which then needs ways to manage it. Forward contracts can lock in the dollar value of expected euro receipts for six to twelve months at a modest cost. A longer-lasting approach follows from Amiti et al. (2014): buying some inputs in euros, such as engines or hydraulic components from European suppliers, would create a natural hedge, since a weaker euro would then lower part of the firm's costs at the same moment it lowers euro revenue. Even a quarter of input purchases in euros would reduce the firm's exposure meaningfully.

Recommendations

First, Blue Ridge should respond to the 10 percent dollar appreciation by raising its euro price by about 3 percent, to roughly EUR 37,500, rather than letting it rise 10 percent under its dollar price list. This choice is supported by the model and by the evidence that manufacturers in competitive foreign markets absorb part of currency shocks.

Second, the firm should move its European customers to a euro price list reviewed each quarter, with a stated policy of passing through about half of cumulative exchange rate changes. That policy makes the firm's pass-through deliberate rather than an accident of its invoicing currency.

Third, the firm should hedge expected euro receipts for the next two quarters with forward contracts and explore sourcing some components in euros as a lasting natural hedge.

Fourth, Blue Ridge should improve its estimate of European demand. The pricing model's recommendation depends on the shape of demand, and the firm can learn about it cheaply by tracking dealer orders against its euro prices and competitors' prices over the next year. If European buyers prove less price-sensitive than assumed, which Berman et al. (2012) suggest is more likely for distinctive products, the firm can pass through more.

Limitations

This analysis rests on a linear demand curve calibrated to a single price and quantity, and the true curve may be more or less sensitive at higher prices. It also assumes that European competitors do not change their own prices, although a weaker euro would leave their euro costs unchanged and give them no reason to. The model ignores dealer inventories, which can delay the effect of a price change by several months, and it treats the exchange rate change as permanent. A temporary movement might justify absorbing even more of it to protect long-term dealer relationships. Finally, Canada, the firm's other major export market, needs its own analysis, since Canadian buyers compare Blue Ridge with American competitors who face the same exchange rate.

Conclusion

Exchange rate pass-through looks like a question for macroeconomists, but for an exporter it is a pricing decision governed by the same principles as any other: marginal cost, the elasticity of demand and the markup that balances them. The evidence from several countries shows that manufacturers in competitive foreign markets typically absorb part of a currency shock, and a simple model of Blue Ridge's European demand confirms that partial pass-through earns more than either extreme. By pricing in euros, adjusting by about half of currency movements and hedging deliberately, the firm can turn an accident of invoicing into a managed policy.

References

Amiti, M., Itskhoki, O., & Konings, J. (2014). Importers, exporters, and exchange rate disconnect. American Economic Review, 104(7), 1942-1978. https://doi.org/10.1257/aer.104.7.1942

Baye, M. R., & Prince, J. T. (2017). Managerial economics and business strategy (9th ed.). McGraw-Hill Education.

Berman, N., Martin, P., & Mayer, T. (2012). How do different exporters react to exchange rate changes? The Quarterly Journal of Economics, 127(1), 437-492. https://doi.org/10.1093/qje/qjr057

Campa, J. M., & Goldberg, L. S. (2005). Exchange rate pass-through into import prices. The Review of Economics and Statistics, 87(4), 679-690. https://doi.org/10.1162/003465305775098189

Gopinath, G., Itskhoki, O., & Rigobon, R. (2010). Currency choice and exchange rate pass-through. American Economic Review, 100(1), 304-336. https://doi.org/10.1257/aer.100.1.304