Modeling price transmission between farm and retail prices: a soft switches approach

Vector error correction models (VECM) are used to model price transmission when farm and retail prices are cointegrated. To allow for nonlinearity in the cointegration process, researchers may specify thresholds to break the error correction process into regimes according to whether the retail price is above, below, or close to its equilibrium value given farm prices. However, because the coefficients in a VECM can change when there is movement from one regime to another, the model can be discontinuous. This implies sudden, ‘hard’ regime changes. In this study, we extend the threshold VECM to include features of smooth transition autoregression (STAR) models. Our approach allows for gradual, soft regime changes. An empirical application to retail cheese and farm milk prices is presented.