KURZERE AUFS.ATZE • KOMMENTARE SHORTER PAPERS t~r COMMENTS

Price Elasticities of EC Imports by Region of Origin: A System Approach

By

Gerrit Faber and Jacques J. Siegers

I. Introduction

T he composition of EC(10i imports 1 from third countries by origin shows substantial changes over the last two decades. There has been a rather stable rise in the shares of Japan and

the newly industrializing countries (NICs) in the imports into the EC (see Table 1). The share of the United States declined from about 20 per cent in 1969 to around 16 per cent in more recent years. Australia, New Zealand and Canada saw their share in EC(10) imports decrease by half. Western European countries outside the EC(10) managed to increase their share in EC(10) imports.

These variations in import shares result from demand and supply side forces. As relative prices of supplying regions change, demand will react, dependent on the magnitude of the import price elasticities. In most traditional trade theory, not much attention has been paid to import demand functions. Instead, comparative advantage in produc- tion was studied in depth and presented as the main driving force of international trade. Demand reactions on price variations deserve attention as these reactions may explain the geographical composition of international trade to some extent. This composition may be irrel- evant in a world of complete multilateral free trade, in practise it may

Remark: The authors are grateful to Bob Lodder for his valuable assistance in the preparation of the econometric part of the paper; they also thank an anonymous referee for his useful suggestions. All errors are ours. 1 In this article the term "EC(10) imports" refers to imports into the European Com- munity of ten member states (i.e. the present EC excluding Spain and Portugal for reasons of data availability) from non-member states.

Faber/Siegers: EC Imports 371

Table 1 - Composition of EC( lO) Imports by Origin, 1969-1985 (per cent of total imports)

Origin country

1. Non-EC Western Europe a

2. United States 3. Japan 4. Australia,

New Zealand,

1969 1972 1975 1978 1981 1982 1983 1984 1985

21.4 23.4 20.4 23.5 21.2 22.1 24 .6 25.2 26.2 20.1 17.3 16.4 15.7 16.3 16.8 16.2 16.2 16.0 2.5 4.0 3.8 4.9 5.3 5.6 6.2 6.4 6.8

Canada 7.5 7.0 4.7 3.9 3.5 3.4 3.3 3.5 3.4 5. NICs b 2.0 2.5 2.6 2.8 3.0 3.1 3.5 3.6 3.7

a Excl. Portugal for reasons of data availability. - b Complete set of data available for Brazil, Singapore and South Korea only.

Source: Eurostat [various issues].

be a sensitive issue in political terms. Trade policy sometimes even consciously distorts relative prices between countr ies o f origin in or- der to create these demand reactions. Regional economic integrat ion and preferential a r rangements between rich and p o o r countr ies are cases in point. 2 F o r governments tha t want to st imulate exports it is relevant to know whether a policy that aims at a decrease o f relative expor t prices - by adjusting the exchange rate or by measures tha t change the domest ic price level - will result in rising exports to certain marke ts and how large this rise will be. A related quest ion is which compet i tors have to be faced in tha t markets .

H o u t h a k k e r and Magee [1969] est imated US impor t funct ions for 16 countr ies o f origin as early as 1969, and found significant differ- ences in impor t price elasticities between regions o f origin. The find- ings o f o ther studies co r robora t ed these results [e.g. Leamer , Stem, 1970; Grossman , 1982]. These studies use impor t funct ions that are specified independent ly o f one ano ther and are est imated accordingly. It is much more sat isfactory f rom a theoretical poin t o f view to estimate the demand funct ions in a system f ramework. This enables the imposi t ion o f cross-equat ion constraints and to obta in results tha t

2 There are numerous examples of discriminative trade policy measures: the European Economic Community, and its many preferential trading arrangements with the (re- maining) countries of the European Free Trade Association, the developing countries in Africa, the Caribbean and the Pacific that signed the Lom6 Treaties; the Caribbean Basin Initiative of the United States is another example.

372 Weltwirtschaftliehes Archiv

are consistent. For the estimation of the price elasticities of EC im- ports, we used a model that was developed by Kohli [1985]. This model has the advantage over previous attempts to estimate import functions in a system framework that it uses the flexible and general translog function. 3

We used the model to estimate EC(10) import demand functions for five regions of origin, viz. non-EC(10) Western Europe, the United States, Japan, other industrialized countries (Australia, New Zealand, and Canada) and some NICs (see Table 1).

In the next section we will describe the model. The empirical implementation and the estimation results will be discussed in Section III while our conclusions are to be found in Section IV.

I I . T h e M o d e l

The technology used in product ion can be represented by the following unit cost function, assuming cost minimization:

py = C (Pml, �9 �9 -, Pml, P~, PL), (1)

in which the p's stand for prices and the subscripts y, mi, K and L denote gross output , imports from region i, capital services and labour services, respectively. The function C (.) is well defined for all positive prices. It is increasing, linearly homogeneous and concave.

We assume that the technology is weakly separable between im- ports and domestic inputs. This enables us to aggregate imports con- sistently [Berndt, Christensen, 1973]. In terms of prices:

Pm = c (Pro1, "" ", P ~ a ) , (2 )

where Pm is the price of aggregate imports and c (.) has the same properties as C (.). The cost minimizing demand for imports from region i, conditional on aggregate imports, can be obtained by differ- entiation of (2) which gives Shephard's Lemma [Shephard, 1953]:

qml = [6C (')/rPmi] qm = di (Pint, "-. ,Pml) qm i = l , . . . , I , (3)

in which qmi is the quantity of imports from region i, and qm is the quantity of aggregate imports. The next step is to specify a functional form for c (.), after which the system of disaggregated import demand functions (3) can be derived and estimated.

3 These previous attempts by Hickman and Lau [1973] and Barten [1971] used lin- earized CES functions.

Faber/Siegers: EC Imports 373

III. Empirical Implementation

The functional form for c (.) we propose is the translog function which is general enough not to impose any prior restrictions on the sign and the size of any elasticity of substitution. This gives:

log (Pm) = Cto + )"~, ~Xi log (Pmi) + �89 ~ flij log (Pmi) log (Pmj) i, j = 1 . . . . . I , (4)

in which the following restrictions apply:

Z ~ i = 0 , 2 E s i = l

Z flij = 0 (restriction of homogeneity) J

flij = flji (restriction of symmetry).

Impor t demand functions (3) can then be derived in share form:

Si = ~i "1- E flij log (pmj), i = 1 . . . . , I , (5) J

where s i = Pmi qmi/(ZPmj qmj)" The system (5) consists of 6 equations; there is one equation for

each supplying region we distinguished and one for the rest of the world. For estimation purposes we omit the last equation of system (5). This transforms the restrictions into:

5 flij = 0 (homogeneity) and

J flij = flji (symmetry) in which i, j = 1 . . . . , 5 .

Price elasticities give the best expression of the possibilities of substitution between regions of origin. The elasticity of the demand for imports from region i with respect to the price of imports from region j (•ij), c a n be calculated as follows [Kohli, 1978]:

ei j = (flu + SiSj)/SJ for i # j i , j = 1, I (6) (flii+s2-si)/si for i = j " ' " "

All data are annual data for the period 1969-1985. The data on EC(10) imports by origin in current ECUs were obtained from Eu- rostat. Instead of EC(10) import prices by origin, which are not to obtain, we used the level of export prices (f. o. b.), expressed in ECU. This implies that the effects of changing trade policies of the EC are not taken into account in the prices used. The data were computed from the I M F International Financial Statistics and from Eurostat (1985). All prices are normalized to unity for 1980.

374 Weltwirtschaftliches Archiv

The system (5) was est imated by use o f the wel l -known "seemingly unre la ted regressions" or SUR.mode l , as developed by Zellner [1962]. The restriction o f homogene i ty was satisfied by implication, as we normal ized the price indices for each year by reference to the price index for one region. The SUR-analysis p roved that the restriction o f symmetry had to be rejected; the results o f the empirical analysis presented in this article have been generated by the model wi thout the restriction o f symmetry, est imated by ord inary least squares.

Autocor re la t ion , a potent ia l p roblem in all t ime series analyses, did not const i tute a problem in our study. Mult icol l ineari ty was de- creased by normalizing the price indices in each year by reference to the price index for one region. Mult icoll ineari ty was reduced to an acceptable level. 4

IV. Empirical Results

Our empirical results are repor ted in Table 2; t-values are shown in parentheses while R2-values are repor ted at the b o t t o m o f the table.

Table 2 - EC Imports by Origin: Parameter Estimates a and R 2 for Each Equation

f l i l

fli2

fli3

f l i4

l i 5 b

R 2

Eq. (1) Eq. (2) Eq. (3) Eq. (4) Eq. (5)

0.214 ** 0.149 ** 0.047 ** 0.031 ** 0.030"* (30.71) (19.98) (11.70) (5.17) (13.79)

0 .027 -0.177"* 0.073 * -0.192"* 0.034" (0.50) (-3.06) (2.36) (-4.14) (2.05) 0.160 ** -0.012 * 0.120 ** -0.095 ** 0.042 **

(3.79) (- 2.26) (4.97) (- 2.59) (3.24) 0.137" 0.062 -0.027 0.117" -0.168

(2.04) (0.86) (-0.71) (2.01) (-0.81) -0.248 ** 0.085 -0.128 ** 0.136 * -0.048 (-3.13) (1.00) (- 2.82) (1.97) (- 1.94) -0.076 0.040 -0.037 0.034 0.139

0.60 0.45 0.70 0.66 0.54

a, = significant at the 5%-rejection level; ** = significant at the l%-rejection level, t-values in parentheses. - b Computation on the basis of the other coeffi-

4 cients, i.e. flis = - ~ flo-

j = l

4 According to Klein's rule. See Maddala [1977, pp. 185 et seq.].

Faber/Siegers: EC Imports 375

It appears that the goodness of fit is quite high, and that most parame- ters are estimated with a rather high degree of precision.

From the estimated parameters and shares in total imports, price elasticities were computed which are reported in Table 3 for selected years. As all own elasticities have the expected negative sign, the estimated elasticities look plausible. There are substantial differences between the elasticities of some regions of origin. Imports from non- EC(10) Western Europe (e11), from the United States (e22) and from the group of newly industrializing countries (e 55) are moderately price elastic (10.51 < e < 11.01) while imports from Australia, New Zealand and Canada are very price elastic (e > 12 I). In contrast, imports from Japan are relatively price inelastic, although the absolute value is rising, reaching the moderate level in 1985.

The advantage of the approach presented here is, that we can also indicate the degree of substitutability between regions of origin. From our results in Table 3 it can be seen that a change in relative prices of non-EC(10) Western Europe exports will affect the share in EC im- ports of the United States as well as Australia, Canada and New Zealand in the same direction as the price change (the cross elasticity being + 1.3 and + 5.8 respectively in 1985). This means that there is a competitive relationship between the imports from these regions of origin and from non-EC(10) Western Europe. The same price change affects the share of Japan and the NICs in the opposite direction (the cross elasticity being - 0.8 and - 0.65 respectively), which means a relation of complementarity between the imports from

Table 3 - EC Imports by Origin: Estimated Price Elasticities for Selected Years

1970 1975 1980 1985 1970 1975 1980 1985

ell -0 .909 --0.928 --0.896 -0.841 e12 -0 .537 --0.622 -0.551 --0.451 e13 -0 .604 --0.634 --0.565 --0.455 e14 1.230 1.263 1.140 0.981 el5 0.021 0.025 0.029 0.037 e21 1.070 1.277 1.308 1.359 e22 -0 .736 -0 .763 --0.764 -0 .765 e23 -0.271 -0 .342 -0 .338 -0.321 e24 -0 .332 -0 .472 --0.489 -0 .496 ~25 0.021 0.025 0.029 0.037 e3x --2.091 - 1.694 -- 1.366 -0 .808 ~32 --3.596 --2.963 --2.459 -1 .604 e33 --0.103 --0.258 --0.358 -0.531

e34 4.153 3.397 2.843 1.924 ca5 0.021 0.025 0.029 0.037 e41 2.595 4.268 5.594 5.850 e42 1.379 2.167 2.809 2.915 e43 -- 1.419 -2 .439 --3.228 -3 .339 e44 --2.598 -3.821 --4.753 --4.909 e45 0.021 0.025 0.029 0.037 e51 --1.387 -1 .122 --0.934 --0.650 e52 - 1.796 - 1.492 -- 1.284 --0.978 esa 0.825 0.695 0.619 0.519 ~s4 2.332 1.910 1.663 1.315 E55 --0.979 --0.975 -0.971 -0 .963

376 Weltwirtschaftliches Archiv

these regions and non-EC(10) Western Europe. The latter relationship may be caused by physical complementarity but also by the shifting of a part of the welfare effect of the initial price change to imports from regions that did not change relative export prices.

These relationships of competition or complementarity can also be indicated for the other regions of origin. Exports from the United States can be substituted for exports from Australia, Canada and New Zealand at the market of the EC (a cross elasticity of + 2.9 in 1985), while imports from Japan are in a relation of competition with im- ports from the NICs at the market of the EC, although this competi- tion is not extremely sharp (the value of the cross elasticity is + 0.5 in 1985). The imports from Australia, New Zealand and Canada are in sharp competition with imports from non-EC(10) Western Europe, Japan and the NICs (the value of the cross elasticities for 1985 were +0.9, + 1.9 and + 1.3 respectively). 5 The NICs are at a relatively low level of competition with all other regions. We may conclude that possibilities of substitution (which means competition between im- ports from different regions of origin) do exist to a limited extent for EC imports from non-EC(10) Western Europe, the United States and Japan, while these possibilities are larger for imports from Australia, New Zealand and Canada.

Our estimates satisfy the condition of homogeneity. By normaliz- ing the price indices for each year by reference to the price index for one region this condition was satisfied. The condition of symmetry was rejected.

V. Conclusions

In the preceding sections we presented a model developed by Kohli that enabled us to estimate the import demand functions of the EC(10) for five regions of origin in one consistent framework for the period 1970-1985. Our results show that price elasticities of import demand vary considerably with respect to regions of origin. Imports from all regions included in the analysis appeared to be moderately to very price elastic, the imports from Japan rose to the level of moderate elasticity only at the end of the period. This implies that exporting countries or regions can affect their share in total exports to the EC by varying their relative export prices.

Substitution possibilities of imports from different regions of origin appear to be limited. Most regions of origin of EC imports face

This is a reflection of the relatively high absolute value of the own price elasticity for imports from Australia, New Zealand and Canada.

Faber/Siegers: EC Imports 377

competition from a limited number of regions. This is not the case for imports from the NICs which show low but positive cross elasticities for all other regions. It is plausible that the varying value of cross elasticities can be partly explained by the commodity composition of the trade flows. However, this composition has not been taken into account in this study.

In general terms our results correspond with Kohli's estimates for price elasticities for the imports of the United States from industrial- ized countries in the years 1960-1979 [Kohli, 1985]. He also found a considerable variation in import price elasticities and limited substitu- tion possibilities. However, Kohli found that imports in the United States from Japan were very price elastic during 1960-1979, while we found as much as a moderate price elasticity for EC imports from Japan only at the end of our period.

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