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3 THEORETICAL FRAMEWORK
This chapter provides the theoretical framework of this study, which underlines the analysis on how market is working to answer the research
objective. From the perspective of economic science, price is an important instrument with many implications, not only on the economy, but also external
effect such as on environment as discussed in this study. A good understanding on how the wood market works, especially on how the wood price is transmitted
from world market to domestic market, is undoubtedly required prior to the analysis of the impact of wood price changes on deforestation. Moreover, such
understanding could also give useful information how shock in the wood market is reflected either in the short or long run equilibrium. Therefore, several theories
on market integration, particularly with regard to spatial market integration is presented, along with the underlying assumptions used in this study.
2.4 Market Integration
Market Integration is one of the most important measures to understand how market works. The existing literature reveals that market integration is
commonly emphasized as a degree of the flow of goods and information across time, space, and form Barret, 1996; Lutz et al 1994. Other defines it as the
extent to which demand and supply, the so-called contestability, in one location of market is transmitted to the other [Fackler 1996, McNew 1996, McNew and
Fackler 1997, Fackler and Goodwin 2001]. Similar to this, Barrett and Li 2002 also define market integration as tradability or contestability between
markets with a focus on physical trade as tradability in the application. Under the terms of market integration, tradability refers to the condition where a good is
traded between markets at the time when arbitrageurs face zero marginal returns contestability. Tradability transfers the information when there is an excess
demand of a good in one market to other market as captured in potential physical flows of the good. The level of tradability of a particular good is determined by
the level of transportability driven by arbitrage forces on transfer costs constraints. Besides related to tradability and contestability, the concept of market
integration also refers to the existence of price co-movement between markets
16 implied by the law of one price LOP as defined by Chen and Knez 1995 who
describe it as existence of law of one price LOP or no-arbitrage opportunities between markets. An integrated market exists when connected markets exhibit
high price correlation [Harris 19790, Ravalion 1986]. If trade occurs between a couple of markets for a homogenous product, the price in the source market P
i
is equal to that in the destination market P
j
plus transfer costs C
i
. In its strong form, The LOP is expressed as
P
i
– P
j
= C
ij
In the competitive equilibrium condition when efficient arbitrage occurs, the changes of price in the source market will be transferred to the destination market
on one-for-one basis immediately. While in the weaker form of LOP, it allows a temporary deviation after a price shock occurs, but then it will return the
equilibrium situation in the long run. The concept of LOP assumes that all related agents in the markets should have all information needed to perform optimal
arbitrage and no-barriers to trade or when transportation costs between market is insignificant [McNew 1996, Jensen 2007]. Nevertheless, some literatures view
this assumption too idealistic which rarely happens in practice. Though two markets do not trade each other, but as long as they are part of
a marketing system, it is still possible for both markets to be integrated. Thus, market integration does not automatically mean market competitiveness [Baulch
1997, Fackler and Goodwin 2001]. In a similar sense, the physical connectivity of arbitrage process does not guarantee the existence of market integration. This is
the case when market agents are indifferent in participating arbitrage. This absence of market integration is called market segmentation which underlines
uncorrelated inter-market prices. This situation occurs when supply and demand in one market cannot affect trade, as well as the price of a homogenous good in
the other market. Since both phenomena implies the LOP, empirical results of spatial price transmission could be similar under markedly different market
regimes [Baulch 1997, Barrett and Li 2002].
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2.5 Spatial Market Efficiency and Equilibrium
