Armington elasticities and terms of trade effects in global CGE models

Staff working paper

This paper by Xiao-guang Zhang was released on 8 February 2006, in conjunction with the staff working paper, The Armington Model.

Armington elasticities specify the degrees of substitution in demand between similar products produced in different countries. They are critical parameters which, along with model structure, data and other parameters, determine the results of policy experiments. Especially when many tariffs are small, trade liberalisation simulations can produce positive or negative welfare outcomes depending on the values assumed for Armington elasticities. The purpose of this paper is to illustrate the effects of the Armington assumption on one of the main factors that affects welfare outcomes, namely, the terms of trade.

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Key points
Contents

Multi-country computable general equilibrium (CGE) models are important tools for analysing tariff and trade policy changes and most such models incorporate the 'Armington assumption'.

The Armington assumption differentiates commodities by their country of origin. It takes the products of an industry which come from different countries to be imperfect substitutes for each other. This model structure enables the construction of complex models based on existing world trade statistics.

The choice of the Armington assumption is an important one as it impacts on the outcomes of policy shocks introduced to CGE models. This is due to both the Armington structure itself and the size of the substitution elasticities, which can have a large effect on the terms of trade (the ratio of export to import prices).

This paper illustrates the complex relationship between the Armington assumption and the terms of trade. In particular, it demonstrates that:

the terms of trade effect of a tariff is positively related to the home country's elasticity of substitution between domestic and imported goods;
the terms of trade effect of a tariff is negatively related to the elasticity of substitution between domestic and imported goods in foreign countries and to all foreign countries' elasticities of substitution between import sources;
increasing proportionally all elasticities of substitution, starting in the range of typical Global Trade Analysis Project (GTAP) default values, does not reduce terms of trade effects much, because these opposing effects approximately offset each other;
- however, reducing proportionally all elasticities of substitution below unity increases the terms of trade effect sharply.

The results on the relationship between Armington elasticities and terms of trade are robust. They are not affected by the size of the tariff-imposing country relative to the rest of the world, nor by the dimension and structure of the model. The results hold for large sophisticated models of global trade, as well as for scaled-down versions.

The results highlight the importance of understanding how the Armington assumption affects simulation results and the importance of having reliable, model-consistent and empirically sound estimates for Armington elasticities in any model that is used to simulate the effects of changes in trade policies.

Background Information

Patrick Jomini (Assistant Commissioner) 03 9653 2176

Preliminaries
Cover, Copyright, Contents, Preface, Acknowledgments, Key Points, Overview

1 Introduction

2 Terms of trade effects in non-Armington models
2.1 A two-country two-good non-Armington pure exchange model
2.2 Terms of trade effects of a tariff in a non-Armington model

3 Terms of trade effects in Armington trade models: one-tier substitution
3.1 One-tier Armington substitution in a two-country pure exchange model
3.2 Terms of trade effects of a tariff in a one-tier Armington model

4 Terms of trade effects in Armington trade models: two-tier substitution
4.1 Two-tier Armington substitution in a three-country pure exchange model
4.2 Terms of trade effects of a uniform tariff in a two-tier Armington model
4.3 Terms of trade effects of a discriminatory tariff in a two-tier Armington model

5 Extensions of the simple Armington model
5.1 Many goods pure exchange models
5.2 Incorporating production with primary factors
5.3 Production with primary factors and intermediate inputs

6 Applied CGE models with Armington assumptions: the case of GTAP

7 Concluding comments

References