Trade creation and trade diversion: New concepts, new methods of measurement

Trade Creation and Trade Diversion: New Concepts,

New Methods of Measurement

By

Ram Dayal and Neeru Dayal

C o n t e n t s : I. R e f i n e m e n t o f t h e C o n c e p t s of T r a d e C r e a t i o n a n d T r a d e D i v e r s i o n : x. V i n e r ' s C o n c e p t s ; 2. M e a d e ' s E x t e n s i o n o f t h e V i n e r C o n c e p t s ; 3. C o n c e p t s A n a l o g o u s t o " I n c o m e E f f e c t " a n d " S u b s t i t u t i o n E f f e c t " o f P r i c e C h a n g e s . - - I f . E x i s t i n g M e t h o d o l o g y of E s t i m a t i n g t h e P r e v a i l i n g C o n c e p t s o f T r a d e C r e a t i o n a n d T r a d e D i v e r s i o n . - - I I I . A n A l t e r n a t i v e E s t i m a t i n g M e t h o d o l o g y . - - IV . A p p l i c a t i o n o f L i n e a r E x p e n - d i t u r e S y s t e m t o t h e A l t e r n a t i v e E s t i m a t i n g M e t h o d o l o g y . - - V. E f f e c t s o f T a r i f f C h a n g e s o n P r i ce s . - - V I . I n t e g r a t e d M o d e l A p p r o a c h . - - A p p e n d i x : F e a s i b i l i t y of E m p i r i c a l A n a l y s i s B a s e d o n t h e I n t e g r a t e d M o d e l .

T here have been many at tempts at measuring the trade creation and

trade diversion effects of a customs union, particularly the European Economic Community (EEC) and the European Free Trade Area

(EFTA), over the past decade and a half. But hardly any of them can be regarded as satisfactory x. A fundamental reason not commonly recognized, for this failure is, perhaps, that the prevailing concepts of trade creation and trade diversion themselves are defective and do not lend themselves to proper statistical measurement. In this paper, an a t tempt is made to refine the concepts of trade creation and trade diversion and to suggest improved methods of their empirical estimation.

Remark: We are thankful to Professor Dr. Bruno Fritsch of the Swiss Federal Ins t i tu te of Technology, Ztirieh, for his professional and material help in preparing this paper.

x For a recent review of these a t tempts , see Willy Sellekaerts, "How Meaningful are Empirical Studies on Trade Creation and Trade Diversion?", Weltwirtscha/tliches Archly, Vol. IO9, x973, pp. 5x9 sqq. The general conclusion of this paper is tha t "all es t imates of trade creation and diversion by the EEC which have been presented in the empirical liter- ature are so much affected by ceteris paribus assumptions, by the choice of the length of the pre- and post-integration periods, by the choice of benchmark year (or years), by the methods to compute income elasticities, changes in trade matrices and in relative shares and by structural changes not at tr ibutable to EEC bu t which occurred during the pre- and post-integration periods (such as trade liberalization among industrial countries and autonomous changes in relative prices), tha t the magni tude of no single est imate should be taken too seriously" (p. 548).

126 R a m D a y a l and N e e r u D a y a l

I. Refinement of the Concepts of Trade Creation and Trade Diversion

I. V i n e r ' s C o n c e p t s

The concepts of trade creation and trade diversion were originally put forward by Viner 1, who in discussing the economic consequences of a customs union, drew the distinction between the t rade creating and trade diverting effects of such a union. Focussing at tent ion on the consequences of the removal, as the result of customs union, of duties which previously had operated as a barrier, partial or complete, to import, Viner remarked, "there will be commodities, which one of the members of the customs union will now newly impor t from the other but which it formerly did not import at all because the price of the protected domestic product was lower than the price at any foreign source plus the duty. This shift in the locus of production as between the two countries is a shift from a high cost to a low cost point, a shift which the free t rader can properly approve as at least a step in the right direction . . . " - - "There will be other commodities which one of the members of the customs union will now newly import from the other, whereas before the customs union it imported them from a third country, because tha t was the cheapest possible source of supply even after the payment of duty. The shift in the locus of production is now not as between the two member countries but as between a low-cost third country and the other, high-cost, member country. This is a shift of the type which the pro- tectionist approves, but it is not the one which the free t rader who understands the logic of his own doctrine can properly approve."

2. M e a d e ' s E x t e n s i o n of t h e V i n e r C o n c e p t s

Much of the discussion and critical examination of the Viner concepts has rested on the welfare costs and benefits of the different consequences of a customs union 2. Perhaps, the most impor tan t in these controversies has been the a t t empt by Meade s to fill the gaps in Viner 's propositions. Taking the trade diversion effect first, Meade took a hypothet ical case in which Belgium and the Netherlands formed a customs union. Before the formation of the union, the Netherlands had a IOO per cent ad valorem import du ty on imports of steel from all sources. The cost of producing

a Jacob Viner, The Customs Union Issue, Carnegie Endowment for International Peace, Studies in the Administration of International Law and Organization, No. xo, New York, London, x95o, pp. 4x sqq.

t The criteria of balance of trade and payments, employment and growth are seldom used in discussing these concepts. I t is these criteria which wilt be used in developing n e w concepts of trade creation and trade diversion.

s j . E. Meade, The Theory o[ Customs Union, Amsterdam, x955, Pp. 29 sqq.

Trade Creation and Trade Diversion 127

a ton of steel was $ ioo in Germany, $ 15o in Belgium and $ 25o in the Netherlands. Therefore, the price in the Netherlands, including impor t duty, was $ 20o for German, $ 300 for Belgian and $ 250 for Dutch steel, and so the Dutch users purchased all their steel requirements from Germany. After the formation of the union, however, the Belgian steel, being exempt from duty, cost only $ 15o in the Netherlands, while the German steel still cost $ 200 (inclusive of IOO per cent duty). The Dutch users shifted their demand from low-cost German steel ($ IOO a ton) to high cost Belgian steel ($15o a ton). This is what Viner would call t rade diversion.

But Meade argued tha t such a view would be suitable where the elasticity of demand was zero. If, on the other hand, the Dutch demand for steel was highly elastic and rose from, say, 1 million to 3 million tons as a result of a fall in the price of imports from $ 200 (German steel, $ IOO cost + $ IOO duty) to $ 15o (Belgian steel, du ty free), the result would be different. On the first 1 million tons, which was diverted f rom low-cost Germany to high-cost Belgium, there is a loss of $ 5o a ton. But now an additional two million tons was being produced in Belgium and sold to the Netherlands. The Dutch consumers ' value of this additional steel was somewhere between $ 200 and $ 15o, whereas the cost to the Belgian producers was $15o, leaving some gain per ton of trade expansion. Viner had not taken this into account.

Meade further explained that the same phenomenon of trade expansion would take place in the case of a customs union whose main direct effect was trade creation and not trade diversion. He used the same example as above but now assumed a du ty of 2o0 per cent before the formation of the customs union. On this basis, German steel costing $ IOO was priced at $ 300 in the Dutch marke t and Belgian steel costing $15o was priced at $ 450 in the Dutch market. Therefore, the Dutch used their own steel which cost $ 250. After the formation of the customs union with Belgium, the Belgian steel was priced at $ 15o in the Dutch market , and so the Dutch switched from the Dutch steel (cost $ 250) to Belgian steel (cost $ 15o ) which resulted in a gain and t rade expansion. Meade explained tha t in addition the Dutch now bought more steel because its price had fallen from $ 25o to $15o. On all this additional consumption, the Dutch got a product which was worth something between $ 250 and $15o a ton to them, whereas it cost the Belgians only $ 15o a ton. There was thus a gain from trade expansion to be added to the advantage of the reduction in cost on the previous consumption of steel by the Dutch.

In this way, Viner's concepts, which are incomplete, have been extended by Meade. Meade has also shown tha t a particular t rade flow need not be exclusively trade creation or trade diversion. I t could be

128 R a m D a y a l and Neeru D a ya l

a mixture of both. Thus, in the second example, when the Dutch replace domestic production by Belgian steel, there is trade creation in the Viner's sense, but also trade expansion in terms of Meade's extended concept. Again, in the first example, when the Dutch replace German steel by Belgian steel, there is trade diversion in Viner's sense, but also trade expansion in terms of Meade's extended concept.

The measurement of trade creation and trade diversion, which has so far been at tempted over the past many years has, in fact, related to Meade's extended concepts. This might appear very surprising, as it is contrary to the almost universal belief that all a t tempts at measurement pertain to the Viner concepts. But it will be shown below that the measurements correspond to Meade's extended concepts and not Viner's concepts. The difficulties of measurement, which have been summarized by Sellekaerts in his article referred to in the opening paragraph of this paper, relate in fact to the difficulties of quantifying Meade's extended terminology, though it is not so realized. The measurement of pure Viner concepts has, perhaps, never been attempted. As they are incomplete, their measurement is not meaningful anyway.

Viner's original concepts as well as Meade's extensions are based on the welfare criterion, but in the empirical estimation it is the trade flows which are measured rather than changes in welfare. The welfare criterion is of obvious importance. I t is, however, outmoded to a considerable extent. The welfare criterion assumes that when imports into a member country from a partner country increase, they imply a shift in the locus of production from a high cost country to a low cost country. However, in the present-day world, cost differentials are not the only or the most important raison d'6tre for international trade. Product differentiation, which has been extended so vastly, is perhaps, a factor of equal or even greater importance. Other factors which supplant or blur the cost factor are sales promotion, credit facilities, delivery terms, activities of multi-national firms, political alignments, similarity of tastes etc.

Most countries are not so much worried about the overall world welfare as they are concerned with ways and means of avoiding serious deficits in their trade and payments positions and undue pressures on their currencies.They are concerned with maintaining adequate rates of economic growth and levels of employment without unheal thy develop- ments in their trade and payments positions. They are concerned with correcting imbalances in the external sectors of their economies without having to enforce unduly restrictive domestic income and price policies. The policy makers in most countries would welcome the quanti ta t ive analysis and empirical measurement of trade creation and trade diversion,

Trade Creation and Trade Diversion I29

if trade creation could be defined as something relating to the overall increase in demand which all the trading partners could proportionately benefit from, and trade diversion as something which helps some countries only at the expense of others including the domestic production in the importing country itself. Such a terminology would clearly indicate tha t trade creation is universally helpful and trade diversion is injurious to many of the trading partners in regard to their balances of trade and payments and income and employment. A breakdown in these terms of changes in trade flows brought about by revisions in the tariff and non-tariff barriers of the trading partners would clearly indicate the beneficial and injurious effects of such revisions.

While the concepts pertinent to internal growth and external balances of a national economy are more realistic and important, the global welfare criterion should, of course, not be altogether ignored. What is required, therefore, is to develop concepts which are primarily relevant to the problems of trade and payments balances but can also be adjusted to suit the criterion of global welfare. Secondly, the concepts should be such that lend themselves to measurement with sound and dependable econometric techniques.

3. C o n c e p t s A n a l o g o u s to " I n c o m e E f f e c t " a n d " S u b s t i t u t i o n E f f e c t " of P r i c e C h a n g e s

These two requirements are fulfilled by concepts similar to the "income effect" and the "substitution effect" of price changes in the domestic demand theory, trade creation corresponding to the "income effect" and trade diversion corresponding to the "substi tution effect." These concepts would lend themselves to sound and reliable measurement techniques, without lacking good logic.

When the price of imports into a country (Netherlands in Meade's example) from the partner country I (Belgium) falls because of the reduction or elimination of tariff, the cost to the consumer of the product falls, and the consequential increase in the demand for the product as a whole is reflected in a corresponding increase in the demand for imports as well as the domestic substitute. This increase in the demand for imports is what Meade calls trade expansion and would like to be included in Viner's concept of trade creation. The trade expansion resulting from the elimination of tariff between member countries may lead to some increase in imports from the third country as well. In the present paper, such increase in imports, whether from a partner country or a third

1 The country reducing tariff is called, in the present discussion, a member country, the country whose products benefit from tariff reduction is called partner country, and the country whose products do not benefit from tariff reduction is called third country.

Weltwirtschaftliches Archly Bd. c x I n . 9

x3o R a m D a y a l and N e e r u D a y a l

country, together with the increase in demand for the domestic product is called trade expansion and corresponds to the income effect of price/ tariff changes 1. I t is realized that the increase in demand for the domestic product is not trade expansion in the ordinary sense. But its inclusion in the concept of trade creation is not without logic. After all, an importing country may take a favourable view or otherwise of increased imports from the partner and third countries, depending on whether there is also a proportionate increase in the demand for and expansion of the domestic industry. Nonetheless, in the estimating procedure, which will be outlined in the next section, this and other components of trade creation are each separately estimated, so that it could be excluded from trade creation if so desired.

Secondly, the fall in the price of imports from the partner country (Belgium) -- whereas the prices of the domestic substitute and those of imports from the third country (Germany) show less or no fall -- makes imports from the partner country cheaper in relation to the other sources of supply, causing a shift in demand (i. e., trade diversion) towards the partner country at the expense of supphes from the domestic industry and imports from the third country. Viner calls the shift towards the partner country from the domestic product as trade creation, and the shift from the third country towards the partner country as trade diversion. In the present paper both these shifts are called trade diversion and correspond to the substitution effect of price or tariff changes.

Again, it might appear inconsistent to call the shift towards a par tner country, to replace the domestic production, as trade diversion, while actually more international trade is created. Of course, trade diversion does not mean a decline in trade; it merely means a shift in trade. On the other hand, part of the flow from the partner country to the member country represents diversion of trade from the third country and cannot, therefore, be called trade creation. Moreover, an increase in imports from a partner country at the expense of the domestic product, even though it may represent a gain in the overall welfare of the union area and may on this ground be cahed trade creation, would not be regarded by the importing country with favour. I t might not only aggravate its balance of trade and payments problem but might also be injurious to its industry and employment. As such, it is a diversion.

As pointed out above, the estimating procedure which will be outhned in this paper, would separately estimate the trade creation and trade

1 The idea of considering trade expansion in relation to the income effect of price/tariff change was suggested by Willy Sellekaerts, The Effect of the EEC on Its Members' Imports ]rom Extra-Area Suppliers, Paper Pres. at the 5th Annual Meeting of the Canadian Econom- ics Association in St. Johns, Newfoundland, i971.

Trade Creation and Trade Diversion I 3 I

diversion elements of each of the bilateral flows between the member country, partner country and the third country, so that even if the shift of demand from the domestic product towards imports from the partner country is to be treated as trade creation, there will be no problem in adding it to the rest of trade creation brought about by a price/tariff change. The summation and interpretation of the figures can be done with full flexibility.

When the tariff on imports into a member country from a partner country is abolished as a result of the formation of the union, all the trade flows within and between the member country, partner country and the third country are affected. There are 9 such bilateral trade flows, and each of these consists of trade creation and trade diversion elements. Therefore, changes in 18 elements in all are to be estimated. However, for the present illustrative purpose, it is sufficient to estimate 3 trade flows (i. e., 6 elements), namely, the trade flows from the partner country and the third country to the member country and the domestic flow in the member country itself. The other 6 flows can be left out in the

Effect o/Reduction or Elimination o/Duty in Customs Union on Imports into a Member Country/tom the Partner Country and the Third Country

Viner 's nomencla ture Nomencla ture Component of change including Meade's of the present

extension paper

I. Imports/ tom partner country to member country

(a) Effect of price competit iveness

(b) Effect of increase in demand in the member country

t rade creat ion i (equals t rade diversion a t 2 (a) and 3 (a)

t rade creat ion (Meade's extension)

2. Imports/rom third country to member country

(a) Effect of price i t rade diversion competi t iveness

(b) Effect of increase in t rade creat ion demand in the member I (Meade's extension) country I

3. Domestic flow in the member country

(a) Effect of price not accounted competit iveness

(b) Effect of increase in no t accounted domestic demand

t rade diversion

t rade creation

t rade diversion t rade creat ion

t rade diversion

t rade creation

9*

132 R a m D a y a l and Nee ru D a y a l

present illustration, because the trade diversion components of these flows would be embodied in the trade diversion components of the 3 flows mentioned above, and the trade creation components would be of a small magnitude. Needless to say, however, that all the 9 flows would be important to the countries concerned and would need to be included in any multi-country trade model. For the present purpose, focussing attention on the three flows just mentioned, a clear tabulation of the distinctions between the Viner concepts (inclusive of Meade's extensions) and the concepts used in the present paper, is given in the table.

Viner's concepts covered only I (a) and 2 (a). The former, i. e., the change in imports from partner country to member country as a result of improved competitiveness of the partner country following the reduction or abolition of tariff, is called by Viner as trade creation. But part of it does not constitute new trade and is merely a diversion of the trade flow which previously took place from the third country to the member country. The present paper calls it trade diversion, because it is a diversion of the third country-member country and member country-member country trade flows. Only part of it is, in fact, new trade, that is, I(a) --2(a), which of course is equal to 3(a). In empirical measurement also, I(a) and I(b) are, under the existing methodology, measured as a single element. I t is, therefore, Meade's extended concept which is measured. Thus Viner's concept of trade creation at i (a) is not entirely trade creation, and its measurement, under the existing methodology, gets inseparably mixed up with the trade diversion part of I (a) itself as well as the trade creation of I (b).

Viner's trade diversion is 2 (a), that is, the changes in imports from the third country to the member country as a result of price competitiveness. But in empirical measurement, 2(a) and 2(b) are measured as a single element and is taken to be trade diversion. In fact, it is a mixture of trade creation and trade diversion.

Viner's 2 (a) reduces global welfare, but 2 (a) is contained in I (a). How can then whole of I (a) increase global welfare, as Viner asserts ?

As against this, the adoption of terminology used in the present paper makes it possible to segregate the above six elements and to estimate them separately, so that summations can be done with full flexibility to suit the purpose of the analysis, whether it is to indicate changes in global welfare, or the effect on balances of trade of the countries concerned, or to assess the consequences for incomes and employment of the affected countries. I t is possible to derive Viner's concepts as well as the concepts which include Meade's extensions. But if Viner's concepts are used and if the existing methods of measurements are adopted, one gets inseparable mixtures of trade creation and trade diversion from which even the


pure Viner concepts cannot be derived. Another advantage of the approach used in the present paper is that the estimation of the various elements provides checks against each other, so that the possibilities of serious estimation errors are avoided.

II. Existing Methodology of Estimating the Prevailing Concepts of Trade Creation and Trade Diversion

Most of the studies on trade creation and trade diversion have related to the determination of the effects of EEC and EFTA. In all these studies, trade creation and trade diversion refer to two different flows, whereas in the terminology suggested in the present paper, each flow is treated as consisting of the trade creation and trade diversion elements.

Prominent among these studies is the one by Balassa 1, wherein he has presented some tentative conclusions regarding the impact of the EEC on trade creation and trade diversion for a 6-year period 1959--1965 after its establishment. Under the assumption that the income-elasticities of import demand would have remained unchanged in the absence of integration, an increase in the income-elasticity of demand for imports from all sources of supply in the post-integration period 1959 --65 compared with the pre-integration period 1953--59 would, according to him, give expression to trade creation proper. These elasticities were obtained by dividing the per cent change in imports by the per cent change in income, and so they represent "gross" elasticities, without netting out the effect of factors other then income s .

x Bela A. Balassa, "Trade Creation and Trade Diversion in the European Common Market", The Economic Journal, Vol. 77, London, i967 , pp. x sqq.

2 This method is similar to the use of a simple regression Log M = b Log Y or, Log M = a + b Log Y, where M is imports into the EEC, Y is income in the EEC and b is the income-elasticity of import demand. If this function is es t imated from the da ta for the pre-integration period 1953--59 and then used to es t imate imports in a post-integration year by inserting into the function the actual income in tha t year, the difference between the imports thus est imated and the actual imports in tha t year would indicate the common market effect. An al ternative regression method is to est imate the function from the da ta for the period i953--65 (i. e., both pre-integration and post-integration) providing for the possibility of a differential elasticity for the post- integrat ion period. Thus Log M = a + b Log Y + a*D + b* (Log Y) �9 D, where D is the dummy variable with the value of 0 for the pre-integration years and uni ty for the post-integration years. In this function a relates to the average level of imports in the pre-integration period and a* relates to the differential over a for the post-integration period. Similarly, b is the income-elasticity for the pre-integration period and b* the elasticity differential for the post-integration period. The common market effect for the year i965, for example, is given by a* + b* Log Y*5. This method is, in fact, t an tamount to est imating a function of the type Log M = a + b Log Y separately for the pre-integration and post-integration periods. The difference between the two a's would be a* and between the two b's would be b*.

x34 R a m D a y a l a n d N e e r u D a y a l

There is some logic in the method used by Balassa or its regression equivalents. When the intra-area tariff is reduced or abolished, the wholesale prices of the intra-area imports should fall and their demand should rise, in addition to any rise in demand due to income expansion. This import expansion effect of tariff reduction or abolition would be reflected in a higher "gross" income-elasticity of import demand in the post-integration period. Of course, the entire change in the income- elasticity of import demand would not necessarily represent the common market effect. For instance, the increase in the elasticity for machinery and transport equipment (which was shown by the imports from partner and third countries) could partly be due to the trend towards more capital intensive character of economic development. In some cases, the increase in the income-elasticity of imports from partner countries could be a continuation of the trend observed in the pre-integration period due, inter alia, to increasing reliance on proximate sources of supply. As Balassa himself points out, "the influence of non-recurring factors, structural changes and uncertainties relating to the underlying relationships also give rise to errors."

But what about a situation in which the import prices show a rise as a result of general inflationary pressures, as did actually happen, for example, in the case of manufactures which experienced an annual price increase of 2.6 per cent ? Such an increase, if it is strong enough to lead to a rise in the domestic prices of the imported products despite tariff reductions, should lead to a fall in the import demand. The positive effect of tariff reductions on import demand would be overshadowed by the opposite effect of inflationary pressures, and if despite this the gross income-elasticity of import demand of manufactures has increased in the post-integration period, would it be right to use it as being indicative of the integration effect ? When the main effect of tariff reduction on imports is through price reduction and such price reduction is overshadowed by the rise in prices due to other factors, any increase in the gross income- elasticity of imports cannot be legitimately ascribed to integration. It would, therefore, appear that unless import prices (cif) have remained reasonably stable, this method cannot be relied upon even for qualitative conclusions, let alone the quantitative estimation of the integration effect.

As for trade diversion, he argued that a fall in the income-elasticity of demand for extra-area 1 imports, following the formation of the EEC, would provide evidence of trade diversion from the third countries to the partner countries. But here also the same objection is applicable: if

i Balassa uses the term extra-area imports in the sense of imports into a member c o u n t r y or countries from third c o u n t r y o r coun t r i e s . I n t r a - a r e a i m p o r t s a re those i n to a m e m b e r c o u n t r y o r coun t r i e s f r o m p a r t n e r coun t r i e s .

T r a d e Crea t ion a n d T r a d e Divers ion I35

prices rise after the formation of the common market due to general inflationary forces, imports might rise less rapidly in relation to income than before integration. This would be reflected in a fall in the gross income-elasticity of extra-area imports. But it would be wrong to ascribe it to the trade diversion effect of integration, as it would be due to the factors other than integration.

Balassa also computed, instead of income-elasticities, the growth rates of imports into the common market in the pre-integration and post-integration periods separately, and then derived the two estimates of 1965 imports by applying the two growth rates to the 1959 imports. The difference between the two estimated imports was ascribed to integrationL This method, too, is liable to the same objections. Moreover, when it is applied to extra-area imports, it has the further drawback of ignoring the growth of total imports or consumption or income in the EEC. As a result of this omission, it is not possible to say how far changes in the growth rates of extra-area imports from the pre-integration to the post-integration period are due to changes in total imports/income/ consumption and how far to the integration itself. This drawback can, however, be mitigated by examining extra-area imports in relation to total imports or consumption 2, or in other words, the share of extra-area imports in total imports or total consumption.

The share of imports in total consumption was used in a s tudy by the EFTA Secretariat for estimating the trade creation and trade diversion effects of EFTA 3. In this study, the trade creation is supposed to take place when higher cost domestic output is replaced by lower cost imports. I t is assumed that where there is a significant protective tariff on some commodity, this is because domestic production costs are higher than those of some potential foreign suppliers. The implication of this is that if the share of imports in consumption rises, trade creation is present. A positive TC (trade creation) in the following expression results from a rise in the share of imports in total consumption of the product in the importing country

TC = Me6 - - E m s 9 -[- 6/5 (m59 - - m64)] Ce6

This m e t h o d c a n be t r a n s l a t e d in to a r eg res s ion of the t y p e L o g M = a -k b t -k a * D -[- b * t . D , where t is t ime in y e a r s w i th x for 1953, 2 for I 954 a n d so on. D is t he d u m m y v a r i a b l e as before a n d M is i m p o r t s f rom all sources . If th i s r eg re s s ion is e s t i m a t e d f r o m the d a t a for the whole per iod , 1 9 5 3 - - 6 5 the c o m m o n m a r k e t effect o n i m p o r t s fo r a n y of t he

p o s t - i n t e g r a t i o n yea r s , s a y 1965, w o u l d be g iven b y a* q- b ' t , w h e r e t w o u l d be I3.

The c o r r e s p o n d i n g regress ion m e t h o d w o u l d b e N = a -b b M -b a * D -k b * M �9 D where N is e x t r a - a r e a i m p o r t s a n d the o t h e r v a r i a b l e s a re the s a m e as before .

�9 E F T A Sec re t a r i a t , The Effects ol the E F T A on the Economics ol Member States, G e n e v a ,

1969.

136 Ram Dayal and Neeru Dayal

where M, C and m stand for imports (from all sources), consumption and the share of imports in consumption. The subscripts denote the years. In this expression, I/5 (ms~ -- ms,) stands for the annual average increase in the share of imports in total consumption. When 6 times this is added to m~,, it gives the extrapolated share for 1965, which multiplied by Cs5 gives the extrapolated imports for 1965 . When these extrapolated imports are subtracted from the actual imports (i. e., M65 ), the positive difference denotes the trade creation effect of EFTA.

Trade diversion is supposed to have taken place when there is a movement from lower to higher cost foreign sources of supply. Since all foreign sources of supply are subject to the same tariff before the formation of the free trade area, the country pattern of supply in the earlier period would reflect the relative costs of production in foreign countries. Therefore, if the share of non-EFTA sources of supply in the consumption of EFTA falls, to the benefit of EFTA sources of supply, there is trade diversion. A negative TD in the following expression, which means that the share of imports from non-EFTA countries in the consumption of a member country has fallen, represents trade diversion.

TD = Ne~ - - Ins0 + 6 / 5 (n~g - - ns4)] Ce6

where N is imports into a member country from non-EFTA countries and n is N/C.

Conceptually, the EFTA study is similar to the s tudy by Balassa. I t uses consumption whereas Balassa uses income as the domestic variable in the importing country. The principal drawbacks of these approaches are summarized below:

(a) In all these studies, the integration effect, whether trade creation or trade diversion, is estimated by the difference between actual imports and extrapolated imports for a post-integration year. The extrapolation of imports is done by a time trend of imports or by relating imports with income or consumption in the importing country. The difference between the actual and estimated imports could be due to (i) autonomous changes in prices in the supplying and importing countries, (ii) changes in income, consumption or some other variable representing macro-economic activity, (iii) changes in variables other than income/consumption and autonomous price movements, (iv) revision of tariff and/or other barriers as a result of integration, and (v) residual errors due to the random error term in the estimating equation, misspecification of the form of the equation, errors in data, omission or misrepre- sentation of certain variables etc. The studies discussed above try to segregate the effect of (ii) only. The remaining difference


between the actual and estimated imports would be due to (i), (iii), (iv) and (v), but it is ascribed only to (iv), i. e., the effect of revision of tariff and/or other barriers to trade as a result of integration. Clearly, it is a totally unreliable way of estimating the integration effect on trade creation or trade diversion. Even if prices are included as an additional variable in the estimating equation, it would amount to segregating the effect of (i) and (ii), so that the difference between the actual and estimated imports would be due to (iii), (iv) and (v). I t would still be wrong to ascribe it to (iv) only. The error term at (v) is often responsible for a divergence of 4- IO per cent between the actual and estimated imports, which might often overshadow the effect of integration. For this reason, the "residual method" used by Batassa, EFTA Secretariat and many others, is highly unreliable for estimating the trade creation and trade diversion effects of integration.

(b) The integration effect, whether trade creation or trade diversion takes place in two stages: the effect of tariff changes on prices and the effect of price changes on trade. These two effects need to be separately estimated, before the trade creation and trade diversion effects of integration can be arrived at.

(c) In these studies, changes in total imports into a member country (i. e., extra-area + intra-area imports) are t reated as trade creation. Actually, these imports represent a mixture of trade creation and trade diversion even in terms of Viner's original definitions, according to which changes in intra-area imports due to price competitiveness (i (a) of the 6 elements listed earlier) are trade creation and changes in extra-area imports due to price competitiveness (2 (a) of the 6 elements) constitute trade diversion. According to Meade's extensions, which account for total imports fully in terms of I (a), I (b), 2 (a) and 2 (b) of the 6 elements, changes in total imports consist of trade creation and trade diversion elements. Again, the Balassa and EFTA studies consider changes in extra-area imports as trade diversion. But according to Meade's terminology, these imports consist of 2 (a) (which is trade diversion) and 2 (b) (which is trade creation), whereas Viner's concept of trade diversion covers only 2 (a) which represents only a part of the extra-area imports 1.

Some of these points are discussed in Sellekaerts, The Effect o] the EEC on Its Members' Imports ]tom Extra-Area Suppliers, op. cir. - - Some additional important drawbacks of the existing methodology are given in idem, "An Optimistic and a Pessimistic Estimate of the Effects of the EEC on Its Extra-Area Suppliers", in: The EEC and the Outsiders, Ed. by Peter Stingelin, Toronto, I972.

I 3 8 R a m D a y a l and N e e r u D a y a l

(d) These studies provide estimates of trade creation and diversion for the past period. They cannot be helpful in projecting the effects of tariff changes on trade creation and diversion for the future.

Another often-quoted study in this field is the one by Kreinin 1. He realized that the influence of the common market on trade flows was mixed up with those of other factors including changes in cif prices. In order to segregate the effect of these factors, he used import demand functions for each member of the EEC, separately for its total imports, imports from partner countries and those from third countries, by regressing the index of volume of imports on real GNP and the ratio of the import price index to the domestic wholesale price index for the period r953--6I. From these functions, he derived estimated imports for each of the post-integration years I 9 6 2 - i965. The difference between the actual and estimated total (i. e., all-source) imports was designated as trade creation, and the difference between actual and estimated imports from third countries was designated as trade diversion.

Even though he segregates the effect of prices, his method is still the "residual" approach, the shortcomings of which are given above. Indeed, Kreinin himself felt that his estimates were "probably unduly influences by random disturbances," since they did not show that the common market effect was growing in yearly succession as it should because the EEC (going through its transitional period) was progressively lowering its internal tariff. Moreover, his being the residual approach, he merely determined the effect of prices on trade but did not determine the effect of tariff changes on prices. His method is, therefore, equivalent to the assumption that the price of the imported product in the domestic market of the importing country changes by the full amount of the tariff change. This may not be so in actual practice, because a reduction in tariff may lead to some increase in the price in the supplying country so that the import price of the importing country (including tariff) would fall less than the cut in tariff. Lastly as in the case of the studies by Balassa and EFTA, Kreinin's estimates of trade creation and trade diversion are, in fact, mixtures of both z.

Kreinin's import demand function was of the type

(I) M = f (Y, Pm/Pd)

x Mordechai E. Kreinin, "Trade Creation and Trade Diversion by the EEC and EFTA", Economia Internazionale, Vol. 22, Genova, x969, pp. 273 sqq.

s For additional significant criticism, see Sellekaerts, "An Optimistic and a Pessimistic Estimate of the Effects of the EEC", op. c/t.


where M is imports, Y is income and Pm and P d a r e the import price and domestic price. The use of a price ratio in the import demand function is also questionable. Most of the import demand functions used these days include a price variable as the ratio of import prices to domestic prices 1. The main drawback of this approach may be illustrated by taking a hypothetical case in which the import price, Pro, and the price of the domestic product competing with imports, Pd, fall by IO per cent each. There would be a consequent rise in the total demand for the product category to which the imports and the domestic substitute belong, as a result of a fall in both Pm and Pd. This would be associated with a rise in the demand for imports M. But according to the commonly used approach as exemplified by the function at (I) there would be no change in M, since the price ratio would show no change. In other words, there would be trade creation in reality, but the function at (I) would show no trade creation s . It is, therefore, worthwhile examining this question in some detail.

1 See for example, Mordechai E. Kreinin, Disaggregated Demand Functions in International Trade, x97x, unpubl. - - Also idem, "Price Elasticities in Internat ional Trade", The Review o/Economics and S~is t ics , Vol. 49, Cambridge, Mass., x967, pp. 51o sqq. - - Idem, "Effect of Tariff Changes on the Prices and Volume of Imports" , The American Economic Review, Vol. 5I, Menasha, Wise., I96I, pp. 3IO sqq. - - R. J. Ball and K. Mavwah, "The U.S. Demand for Imports, I948--I958", The Review o! Economics and Statistics, Vol. 44, 1962, PP. 395 sqq. - - Lawrence H. Officer and Jules R. Hurtubise, "Price Effects of the Kennedy Round on Canadian Trade", ibid., Vol. 5I, I969, pp. 32o sqq. - - H.S. Houthakker and Stephen P. Magee, "Income and Price Elasticities in World Trade", ibid., pp. x i i sqq. - - Frans Meyer zu Schlochtern and Akira Yajima, "OECD Trade Model: I97O Version", in: OECD Economic Outlook, Occasional Studies, Paris, i97 i , pp. 39 sqq. - - J. Johnston and Margaret Henderson, "Assessing the Effects of the Import Surcharge", The Manchester School o/ Economic and Social Studies, Vol. 35, I967, PP. 89 sqq. - - I. G. Black, J. E. Kidgell and G. F. Ray, Fore- casting Imports: A Re-Examination, National Inst i tute, Economic Review, No. 42, London, 1967. - - W. E. Norton, G. H. Jackson and K. M. Sweeny, "A Demand Equat ion for Im- ports", The Economic Record, Vol. 45, Melbourne, x969, pp. 589 sqq. - - Asko Korpela, Effect ol Tariff on Imports to Finland, Helsinki, x97I. - - Irving B. Kravis and Robert E. Lipsey, Price Competitiveness in World Trade, National Bureau of Economic Research, Studies in International Economic Relations, 6, New York, I97I. - - R. G. Gregory, "Uni ted States Imports and Internal Pressure of Demand, I948--68", The American Economic Review, Vol. 6i, I97I, pp. 28 sqq. - - Lawrence B. Krause, "United States Imports, I947-- I958" , Econometrica, Vol. 3% New Haven, Conn., 1962, pp. 22x sqq.

s Strictly speaking, this trade creation is in the nature of the terminology used by Meade, as it arises from the expansion of demand. But even in terms of Viner's concept, there should be trade creation when the import price, Pro, falls (as a result of a cut in tariff) due to the substi tution of domestic product by imports. Viner's tacit assumption was tha t the price of the domestic substi tute either did not change, or if i t did change its effect was separately accounted for - - an argument for t reat ing the two prices as separate variables rather than a single ratio.

14o R a m D a y a l a n d N e e r u D a y a l

The idea tha t demand is a function of relative prices is as old as economics itself. But the conditions under which it is valid needs to be clearly distinguished. This idea is a corollary to the proport ionali ty relation in demand theory as derived from the conditions of uti l i ty maximization. Let the util i ty function be

U (ql , qs) ~- al ql + a2 qs - - 1/2 (ql) s - - 1/2 (qs) s

where ql and qs are the quantities of two goods consumed; they m a y be two separate domestic products; or, ql m a y be imports and q2 its domestic substitute�9 Then, it can be shown tha t if the consumers t ry to maximize their total utility, their demand functions for ql and qs would be

(al Ps - - as P1) Ps + YP1 (as P1 - - al Ps) P1 + Y P s (2) q~ ---- p** -5 p~ q , ----- p~ -5 p~

where P1 and Ps are the prices of q~ and qs and Y = P1 ql -5 Ps qs, tha t is the total expenditure on ql and qs. ~

If the utility function is not additive, as above, but has a multiplicative term such as (r/2) (ql qs), then

U (ql, q*) = a l ql -5 a2 qs - - I /2 (ql)* - - I /2 (q,)S _ (r/2) (ql qs)

and the demand functions would be

(ax Ps - - as P~) P~ + (P~ - - rPs/2) Y (2a) ql---- p~ + p ~ _ r p 1 P , ,

(a s P1 - - a~ Ps) P~ + (Ps - - rP~/2) Y

qs = p~ + p ~ _ r p 1P~

Since each term in the numerator and denominator of these demand functions is bilinear or quadratic in prices and expenditure, it follows tha t if all prices and expenditure increased by the same proportion,

1 The cond i t ions for m a x i m i z i n g u t i l i t y ~U/~q i = kP i a re

ql + XPx = a l ; q , + XP, = as; Pxql + P ,qa = Y

These th ree e q u a t i o n s give

ql --1

q , = 0

k P1

0 p , ~ . - - 1 al

as

Y

f rom w h i c h the func t i ons for q l a n d q , a re o b t a i n e d , as s h o w n in the tex t .

Trade Creation and Trade Diversion I 4 I

there would be no increase in demand. Such a demand function is called homogeneous of degree zero. This would seem to indicate tha t if in the import demand function at (I), Pm and Pd increased by the same proportion, there would be no change in imports and tha t the objection raised earlier to this demand formulation on the grounds of its failure to capture the trade creation effect is not valid.

But there are important differences between the demand function at (2) and that at (I). In the demand function at (2), Y represents the total expenditure on those products whose prices form the variables in the function. In the import demand function at (I), Y is the activity variable, which has a different and wider coverage than the imported and domestic product whose prices form the variables in the function. If the same utility analysis is applied to the variables in (~), the demand for imports would not come out to be bilinear or quadratic in prices as at (z), but would have linear or other terms as well, so that it would not be homogeneous of degree zero. Secondly, in the demand function at (z), if all prices increased by a given proportion, Y would automatically increase by the same proportion, since Y represents the budget (i. e., total income or expenditure) and is, therefore, close-ended, there being nothing outside it. In the import demand function, Y, whether it is income/expenditure or a sectoral variable, need not automatically increase by the same proportion as Pm and Pd, either because Y is not close-ended or because it has a wider coverage than the products whose prices are represented in the function. The result would be that the multiple of Y and a price variable would not correspond to a second degree term, like P~ or YP1 or P1 P~. Thirdly, in the demand function at (2), all prices are represented as separate variables and are bilinear or quadratic, whereas in the import demand function at (I), Pm and Pa form a single price variable (i. e., the price ratio) barring the determination of the effect of each price variable separately. Fourthly, in the demand function at (2), the denominator is a general price which is the sum or average of all prices (or, rather the sum of squares of all prices) and this denominator is applicable to Y as well. In the context of an import demand function, the denominator would be the sum of squares of the domestic and import prices. But in the import function at (I), the denominator is a single price and this denominator is not applicable to the activity variable. Such a formulation does not satisfy the proportionality relation, which is the basis for using relative prices. I t is not homogeneous of degree zero. Fifthly, the statement that if all prices and incomes increase by the same proportion, there would be no change in demand does not mean that prices have no demand creating effect, but it should rather be interpreted to mean that the demand creating effect (positive or negative) of a change in the own

I42 R a m D a y a l and N e e r u D a y a l

price of a product is cancelled out by the opposite effects of similar changes in the prices of other products. This interpretation, which calls for the use of each price as a separate variable, is all the more valid in empirical analysis of the actual situation, which seldom conforms to the theoretical pattern underlying the proportionali ty relation. A recent s tudy has fitted import functions using price ratios and separate prices; it concludes that the estimates based on the latter approach are more reasonable x.

III. An Alternative Estimating Methodology

What is needed is an import demand function, which while being consistent with the demand theory, would clearly bring out in separable form the trade creation and trade diversion effects of a price change, and would also be suitable for analysing the all-source as well as source- wise imports. The starting point for developing such a demand function 2 is the usual assumption in the demand theory, according to which the import demand of a country for a particular product category from different trading partners, including the domestic source of supply, would be so determined as to maximize util i ty for a given total expenditure on the product category (if the product category is for direct consumption) or to minimize cost or expenditure for a given quant i ty used (if the product category is a raw material or an intermediate product). The necessary conditions for such maximization or minimization are tha t the marginal utility (fi) per dollar (that is, f i /P i ) of imports from source i would tend to be equal to the marginal utility (x) of total money expenditure on the product category. That is fi/Pi = x (i = I . . . . . . n). Or, alternatively, the price of a unit of imports from any source would tend to be equal to the value of its utility to the importing country. That is

i Trace Murray and Peter J. Ginman, "An Empirical Examina t ion of the Tradi t ional Aggregate Import Demand Model", The Review o! Economics amt Statistics, Vol. 58, x976, PP. 75 sqq. - - Also see for example, Edward E. Learner and Robert M. Stern, Quantitative International Economics, Boston, I97o. They observe tha t the use of price ratio in an import demand function is "based on the assumption tha t individual consumers display the absence of money illusion. That is, the doubling of prices and money incomes will leave the quant i ty demanded unchanged. The point a t issue is whether we are so confident concerning the absence of money illusion tha t we will impose this presumption on the data, or whether the da ta should be allowed to support or to contradict the absence of money illusion hypoth- esis. In our opinion, the theoretical support for the absence of mouey illusion is not suffi- ciently strong to just ify" the use of price ratios (ibid., p. xo).

, The derivation of this demand function which follows, is based on the t radi t ional demand analysis. I t is given here fully not only because some adapta t ion of the t radi t ional analysis is needed to suit its application to import demand, but also in order to make the discussion self-contained.

T r a d e Creation a n d T r a d e Dive r s ion r43

Pi = Pfi, where P (without a subscript) is a kind of overall unit value for the product category and can be viewed as the marginal cost of satisfying a given wantS.

A country's decbion to draw supplies of the product category in question from different sources would be governed by the total expenditure on that commodity (i. e., V : ~ Pi Mi) and the utility maximizing

i conditions which are either fi/Pi : x or Pi : Pfi.

Now, when the price of the product from any one source of supply changes, it will alter the marginal util ity per dollar of the supply from

1 L e t the u t i l i t y f u n c t i o n he U = f (M1, . . . . , Mu) , whe re M i (i = x, . , , . , ~) xre t he quan t i t i e s i m p o r t e d f r o m each source of supp ly , i n c l u d i n g those d r a w n f r o m the d o m e s t i c

source. The to ta l e x p e n d i t u r e of the i m p o r t i n g c o u n t r y on the p r o d u c t c a t e g o r y is V = ~ .P iMi , where P i3 the p~ice of M i in the m a r k e t of the i m p o r t i n g c o u n t r y . T a k i n g u p the i

m a x i m i z a t i o n o[ U [or g iven e x p e n d i t u r e , we h a v e

Z = O--]~Pi~i = Maximum i=]

where k is the L a g t a n g i a n mul t ip l i e r a n d c a n be v iewed as the m a r g i n a l u l i l i l y of t o t a l

expend i t u r e . The d i f fe ren t i a t ion gives

@Z/~Mi = l i - ),Pi = 0 (where fi = 8U/~Mi)

so t h a t

fi]Pi = ~.

Or a l t e rna t i ve ly ,

Z* = P U - - ~ P iMi i

where P w i t h o u t a s u b s c r i p t is the price of U, i. e., the overal l pr ice of the p r o d u c t c o n s u m e d

or the m a r g i n a l cost of w a n t sa t i s fac t ion . I t is i/X.

8Z* = P f idMi ~ P i d M i = 0

so t h a t Pi = Pfi

The second o rde r condi t ior ts for m a x i m i z a t i o n a re

d IZ = p F, F. [ t idMtdMj (where fi] = ~fi]~Mj)

sub~ec~ ~v n o c h a n g e in m o ~ e y exl~e~dit~te, w h i c h rr, e ans

dZ = ~|jdMi = 0 i

Th i s m e a n s t h a t the d e l e r m i n a n t

7 0 f:l i~ . . . . . . fn

I f 1 f l l fl~ . . . . . . f in (i) D = I is n e g a t i v e defini te

ff~ f,~ f . . . . . . . . f m

: fnl fnz . . . . . . f n n


that source and therefore upset its equality with marginal utilities of the supplies from other sources. As a result of this, there will be a tendency in the importing country to reshuffle its supplies from different sources, decreasing its imports from some sources and replacing them by imports from other sources. In other words, there would be a tendency towards trade diversion.

Moreover, the initial change in the price of the product from any one source of supply will bring about a change in the total money expenditure (V) on the product category as a whole in the importing country. This will lead to a change in the marginal utility of money expenditure, i .e. , z. Consequently, the marginal utility per dollar of supplies from every source would differ from X. As a result of this, and as the direct result of the change in total money expenditure, there will be a tendency towards a proportionate change (increase or decrease, as the case may be) of imports from each source. In other words, there will be a tendency towards trade creation (positive or negative).

The extent of these changes can be assessed by determining the extent to which the distribution of total expenditure on the product category as between different sources of supply as well as the util i ty maximizing conditions ( P i = Pfi) are affected by a change in the price of imports from a particular source, say P~, and the consequential change in V. In other words, what is needed is the algebraic differentiation of V = ~ P i M i and Pi = Pfi with respect to P~ and V. x This procedure

i leads to the following expressions:

1 Fi rs t d i f fe ren t ia t ing V ~ ~ PiMi and Pi = Pfi w i t h respec t to Ps , we ge t i

- - M s = 0 + Px (~M~/aP2) + P t (~M~/~Pt) + . . . + Pn (~Mn/~Pg)

0 = (Pa/P s) (~P/~P2) + f i x (~M~/~Pt) + fx2 (~M,/~P~) + . . . + f m (~Mn/~P,)

(ii) x /P = (PJP~) (~P/~Ps) + f,x (~Mx/aP,) + f , , (0Ms/~P*) + . - . + f m (~Mn/~P2)

Solving these equa t ions for OM1/~Ps, we ge t

(iii) (0MI/~P,).V = D, /D = M, {DI,/D ) - - x /P (D,, /D)

where D is as in (i) in the footnote x on page x43. Dj = D in which the j t h co lmnn is replaced b y the vec tor on the le f t -hand side of the equa t ions a t {ii} above. Dij = Minor of the e lement in the i t h r aw and j t h co lumn of D i (or D). The express ion (OMI/OP2)" V denotes the effect of a small un i t change in the price in c o u n t r y ", on the i m p o r t i n g c o u n t r y ' s d e m a n d for the p roduc t of coun t ry I , when to ta l m o n e y expend i t u r e of the i m p o r t i n g c o u n t r y on the p roduc t f rom all sources of s u p p l y (i. e., V) is he ld cons tan t .

Repea t ing the above process of d i f ferent ia t ion w i t h respec t t o P~, we ge t

(iv) (~Ml/OPl).V = D , / D = - - M~ (D~/D) - - x /P (D~/D)

Trade Creat ion and T r a d e Divers ion x45

(a) The trade creation effect on imports from source I, i. e., M 1 when the price P2 of imports from source 2 changes by dP~, is given by

(3) - - M s (aM1/aV) dPs

(b) The total price effect on imports from source I, when the price of imports from source 2 changes by dPz, is given by

(4) 4- (aM1/aPs).v dPs

(c) The trade diversion effect is given by the sum of these two, i.e.,

(5) -- M s (aM1/aV) dP 2 4- (aM1/aPz) v dP2 1

Next , by d i f ferent ia t ing V = 2~ Pi Mi and Pi = Pfi w i th respect to V, we get i

i = 0 + Pa (SMz/@V) + Pa (@M,/@V) + . . . + Pn (OMn/OV)

0 = (P~/P') (~P/~V) + f** (aMx/~V) + fla (SMa/SV) + . . . + f m (OMn/OV)

(v) 0 = (p , /pa) (SP/SV) + fat (SM1/SV) + f,a (SM,/SV) + . . . + fan (SMn/SV)

0 = (Pn/P a) (SP/SV) + f m (SMx/SV) + fna (SMa/SV) + . . . + fna (SMa/SV)

This gives

(vi)

(vii)

~MI/~V = D~/D = - - D , J D Simi lar ly , we have

8M,/SV = D~/D = DxdD

where D]* = D in which the j th co lumn is rep laced b y the vec tor on the l e f t -hand s ide of (v) above and Dij is the same as before.

These three expressions are der ived d i rec t ly f rom the de r iva t ions g iven in the preceding footnote. Subs t i t u t i ng (vi) and (vii) in to (iii) and (iv), we get

(viii) (0M,/SP,).V = - - [M~ (0M,/SV) + (x/P) {Dss/D) ]

(ix) (@Ms/SP,).V = -- [M, (@M2/@V) + (x/P) (Dsa/D)] because Dan = Dn

The first term on the right-hand side of (viii) is the expenditure or cost effect of a change

in Ps on the demand for M,. VChen Ps increases by dPa, the total money expenditure or cost

of the impor t ing coun t ry would increase b y (@V/@Pa) dP , = MadP a. This increase in cost resul ts in an increase in P (i. e., average cost of the p roduc t ca tegory from all sources of supply) , a fall in the d e m a n d for the p roduc t ca tegory from all sources, a p r o p o r t i o n a t e decl ine in the d e m a n d for M 1 to the ex t en t of - - (@MJ@V) MsdPv This is the cost or expend i - tu re effect of an increase in the price Ps of impor t s M 2 on the d e m a n d for impor t s M,. I t is the first t e rm on the r igh t -hand side of (viii) which is re -produced as (3) in the m a i n t ex t . I t represents the t rade crea t ion effect, pos i t ive or negat ive .

The second t e rm on the r igh t -hand side of (viii) is the subs t i t u t i on effect. The s u b s t i t u t i o n effect can be defined as the increase in d e m a n d for M, as a resu l t of ( i) a change in Pa of dPa and (2) a compensa to ry change in to ta l m o n e y cost or expend i t u r e to keep the real cost or expend i tu re unchanged, i. e., a change of M,dP v The subs t i t u t i on effect therefore is (@Ma/~Pa). V dPa + (SM1/~V) MadPa, which is equa l to - - I / P (Dss/D). Here, there is no change in to ta l d e m a n d b u t only a re-shuffle of impor t s f rom the c o u n t r y whose p roduc t is now dearer to the impor t s from other sources. Th is t e rm appears as (5) in the m a i n t ex t .

The le f t -hand side of (viii) be ing the sum of the cost effect and the subs t i t u t i on effect, represents the to ta l price effect, i. e., t rade crea t ion + t rade divers ion. Th is is r ep roduced as (4) in the m a i n text .

Weltwirtschaftliches Archiv Bd. c x l n . *o

146 R a m D a y a t and N e e r u D a y a l

In these expressions, a term like (~M1/SPs)" v means an increase in the demand for M1 due to a small unit increase in P, when the total money expenditure, V, is held constant.

I t has been explained above that the equilibrium imports from different sources of supply are given by the conditions P i ---- Pfi and the budget constraint V = Z P i M i . The solution of these equations gives the demand

i for imports from any country as a function of prices of imports from different sources and total money expenditure. That is

(6) Mi = Mi (P~ . . . . . . . Pn, V)

This is a general demand function, and the above-mentioned expressions for trade creation, trade diversion and total price effects hold good whatever the specific form of the demand function. The change in imports, M1, for example, as a result of a unit change in P2, is given by

dM1/dP s = (~MJ~P~). v dP1/dPs + (OM~/~Ps). v dPs/dPs + . . . . . .

. . . . . . . . + (~M~/~Pn). v dPn/dP2 + (~M~/~V) dV/dP z

(7) = (~M~/~Ps).v + (~il /~V) Ms because ~Pj/~Ps ~--- 0 (j # 2)

and 0V/~Ps = Ms

A comparison of this with (viii) of the footnote on page 145 shows that the first term on the right-hand side of (7) above, which is the coefficient 1 of Ps in (6) represents the total price effect. The second term which is the coefficient of V in the statistical import demand function (6) represents, when multiplied by M v the trade creation effect (i. e., the cost or expenditure effect). The sum of the two (actually it could be the difference of the two, if they have opposite signs) would give the trade diversion effect.

With this theoretical exposition, it is now possible to estimate the 18 elements of trade creation and trade diversion, 2 each of the 9 bilateral flows within and between a member country, a partner country and a third country. As already explained, when a member country reduces or abolishes its tariff on imports from a partner country, it affects all the nine bilateral trade flows consisting of 18 elements of trade creation and trade diversion. Of these, as already explained, it is sufficient to focus at tention on only 6 elements for the present purpose of exposition. The three

1 If the demand funct ion is l inear, t hen (~MJ~P~).V is j u s t the coefficient of P~. If the demand funct ion is log-l inear (with b as the coefficient of P2) then (aM~/~P~).V ~ - - b M J P s . If the funct ion is of the form

PtM1 = bo + b~Pl + b~P~ + . . . . + bnP n + rV

then (~Mx/~P2).V = b, /P~.


bilateral flows a r e M21 , M31 and M u, that is, imports from country 2 (i.e., partner country) to country I (i. e., member country), imports from country 3 (i.e., third country) to country I, and domestic flow within the member country. Each of these flows would depend upon the total expenditure or income in the member country and the prices of supplies from each of the three sources. For example, the demand for imports from country 3 to country I would be

(8) M31 = ao + al Pn + a2 P21 + a3 P31 + a4V

where Pij are the prices of imports from country i to country j, inclusive of tariff, and V is the expenditure or income in the importing country.

Now, when country I reduces tariff on imports from country 2, Pll falls 1. Let the fall in price be dP21. The trade diversion effect of a fall in P~I would be given by

(8a) (T.D.)s~ = (0isl/0P~x).v dP21 + (~Msl/~V) M21dP~l

= (as + a4 Msx) dP~l

This would represent the diversion of member country's imports from country 3 to country 2. The trade creation effect of a fall in P21 is

(8b) (T.C.)s 1 = (~M3x/aV) M2x dPsl = a t M~I dPsx

Similar effects on the flow from country 2 to country I can be seen from the function relating to imports from country 2 to country I. That is

(9) Ms1 = bo + bl Pxl + bs Psi + b3 Psi + b4 V

This gives

(9a) (T.n.)sx = (~M21/0P21). v dPsx + (0Msx/~V) M,1 dPsx = (b 2 + b~ M~x ) dP~x

(9 b) (T.C.)~ x = (0M~I/0V) M2x dP2t = b4 M~t dP~x

The domestic flow in country I would also be affected, the extent of which would be determined by the demand function for domestic supplies.

(IO) Mn =Co + c x P x 1 + c 2 P 2 1 + % P s l + c 4 V

This gives

(Ioa) (T.D.)ll -~-- (OMIJOPzl). v dPzl + (0 i l l /0v) M21 dP,1 = (% + c4 M2x) dP21

x To what extent Ptt would fall, will be considered in the next section.

IO*

14 8 Ram Dayal and Neeru Dayal

and

(lob) (T.C.)n = (~Mn/OV) M21 dPsl = c, M,x dP21

This completes the 6 elements listed in the table on page 131.

IV. Application of Linear Expenditure System to the Alternative Estimating Methodology

Now, the import demand functions like (8), (9) and (Io) can be statistically estimated without any difficulty if imports from only 2--3 sources are to be considered and only 2--3 price variables are to be included in the function. But when more than 2--3 sources of supply are to be separately considered, it would be necessary to include several price variables in addition to other variables in any bilateral import demand function like (8), (9) and (IO). I t becomes difficult to undertake the statistical estimation of such a function, since the time series data generally do not have enough number of "observations" to permit the estimation of regressions involving more than 4- -5 variables.

However, this problem can be satisfactorily tackled by a method similar to the analysis of the linear expenditure system (LES) undertaken by Richard Stone in his s tudy of the British domestic demand 1. This method, which is slightly adjusted here to suit the problem of import demand rather than domestic demand, is essentially one of reducing the number of variables in the demand function by incorporating into it the three conditions which an import demand function should normally satisfy. These are (i) additivity, tha t is, the demand for a product category in a country would equal the sum of imports of the product category from various sources plus the demand met from the domestic sources of supply; (ii) homogeneity, that is, if the prices of the product from different sources of supply and the total expenditure on the product increase by the same proportion, the money value of supply from any one source increases by the same proportion, which means that the supply from any one source in real terms remains unchanged; (iii) substitution symmetry, that is, for an importing country, the substitution effect on imports from source i when the price of imports from source j changes by a unit is equal to the effect on imports from source j when the price of imports from source i changes by a unit.

For building up these three conditions into the demand function, Stone took the demand function in value terms. For example, the value of imports from country 2 to country I is a function of total expenditure

x Richard Stone "Linear Expenditure Systems and Demand Analysis: An Application to the Pattern of British Demand", The Economic, Journal, Vol. 64, x954, pp. 5xx sqq.


in current value terms in country I and the prices of imports from the various sources of supply including the domestic source. Thus,

(II) MzlP~I = a~lV1 + b ~ , n P n +bz , zx Pzl + . . . . +b~,nxPnl

The general form of this function for imports into country I is

(12) Mj l P j l = ajl Vz + X b L K1 PK1 K

which in matr ix terms can be written as

(13) PM ---- aV + BP where,

P l l

Psi

Pnl

I P n 0 . . 0~

= 0 P21 "" 0

o i. L_j M =

M l l

M~I I

11

a = I a21

l a n l

B =

_ m

bl, 11 bl, ~1 �9 �9 bl, nl

b2,11 b2, 21 �9 �9 bz,,u . . . . . . . . . . . . . . . .

bn, 11 bn, sz �9 �9 bn, nl

above are built into this demand function, the function becomes

(14) PM = a V + ( 1 - - a i ' ) M ~ ~

Or,

(15) P M = P M ~ + a (V - - i ~ ~)

where M ~ with the superscript o indicates the vector of initial or base period imports x from which the differentials are worked out. These imports do not depend upon prices and may, perhaps, be likened to fixed

costs in industrial economics, l~I ~ is a diagonalized vector of such imports and i is a vector whose each element is unity. The matr ix of coefficients of the price variables is given by

(16) B = (1 - - ai') 1~I ~ 9.

t The initial optimal quantit ies are distinguished with a superscript and the changes are measures from this optimal si tuation in Henri Theil, Economics ~ml In/orrr~io~ Theory, Studies in Mathematical and Managerial Economics, Vol. 7, Amsterdam, x967, Chapter 6: Consumer Allocation Problem.

The derivations at (t4), (I5) and (x6) are explained in Stone's paper, op. cir. But there is a simpler way of deriving them, and this is explained below. The matr ix of import demand functions for country i is

(i) l~M = aV + BP as in the text.

The substi tut ion symmet ry can be written in matr ix notat ion as

(ii) (0M/SP) + (SM/SV)M' = (8M/SP)' + M (SMISV)'

Stone has shown that when the three conditions mentioned

15o R a m D a y a l and N e e r u D a y a l

A typical import demand function of the matrix at (15) would be

( I 5 a ) P j l Mj l = P j 1 M 7 1 + a j l (V - - ~. M 7 1 P j l ) J

It will be observed that the reconstituted import demand function at (15) does not require any estimation of the price coefficients by the regression procedure. I t requires only the coefficients of total expenditure or income to be estimated by regression. The price coefficients B are derived from the coefficient of expenditure a by using the relation at (16). This greatly simplifies the estimation work.

The statistical estimation of (15) depends upon the interpretation given to M ~ If this is treated as the initial or base period imports or the average imports of the data series being used, then the only unknown in (15) is a and this can be estimated by simple regression, i.e., the regression of imports from any one source in value terms upon the total expenditure adjusted for the total value of the base period imports from all sources, including the domestic sourceL If, on the other hand, M ~

Applying these derivatives to the import demand function (i), we get

(iii) 0 (PM)/~P = P (aM/~P) + M ~ B Or, (aM/OP) = ~- -1 ( B - - lVl)

and similarly,

(iv) ~ (PM)/0V = I~(~M/~V) = a or, (~M/~V) = 1 ~--1 a

Inserting these derivatives into the subst i tut ion symmet ry at (ii), gives the subst i tu t ion symmet ry based on the import demand function (i). We get

~- -1 (B - - ~I ~ + p - -1 aM' = ( B ' - - ~I ~ I~--1 + Ma' I~---1 Or,

(v) t~--1 [ B - - ( 1 - - a i ' ) ~1o] = [ B ' - - ~ I o ( 1 - - i a ' ) ] ~ - -1

The conditions under which the two sides of (v) are equal are either a = 0 and B = B ' (i. e., B is symmetric) which in fact means tha t there is no income effect (trade creation) and tha t the price effect consists only of the subst i tut ion effect (trade diversion). Or else, the expression in square brackets is zero. Tha t is,

(vi) B = (1 - - ai') l~IO.

This is more realistic. With this restriction, the import demand function at (i) becomes

(vii) tiM = aV + (1 - - a i ' ) 1~o p Or,

(viii) PM = PM o + a ( V - - i ~ ~)

The condition at (vi) or the import demand function at (vii) or (viii) would necessarily sat isfy the additivity requirement since the subst i tut ion symmet ry at (ii) is itself based on the additivity constraint. Similarly, the homogeneity condition will be satisfied by (vii) and (viii) because the original import demand function (i) is homogeneous of degree x.

x This interpretation derives support from another way in which the function at (I5) can be derived. I t can be viewed as representing the relation between imports and total

Trade Crea t ion and Trade Divers ion I 5 I

is regarded as unknown, then the estimation procedure given by Stone can be used, or a technique developed by Solari later can be adopted 1.

The linear expenditure system, which has been extensively used in the analysis of domestic expenditure, has recently begun to be used in allocating total imports by a country among the various sources of supply 2. For example in the COMET model of the EEC 8, the idea of "an allocation of fixed total commodity imports over countries of origin" is adopted as in the LES. An equation of the form

log m i = aoi + all log m + a~ log (P~/Pm)

is set up, where m is total imports of a country, m i is its imports from source i, Pm is the price of total imports, Pn~ is the price of imports from source i. The "difficulty of obtaining reasonable values" for the coefficient of the price variable (i.e., a~) is recognized. To overcome this difficulty, a theoretical relationship between the coefficients of m and (P~/Pm) is used, viz.,

a~t ~ - ~ ali

This relationship is derived by minimizing the cost of total imports subject to the production function in which imports are used. In the LES, the same kind of minimization is used in deriving the substitution symmetry 4 which in turn is substituted into the import allocation equation (II) to derive the LES estimating equation (14) or (15) and the relationship (16) between the price coefficients and the all-source imports coefficient.

expend i tu re or income only, holding prices cons tan t . Thus, in the in i t ia l or base period, we have

PM ~ = aV ~ + BP

and in the cur rent period

PM = aV + BP

No superscr ip t is g iven to P because prices are a s sumed to be cons t an t ; t hey are the same in the base period and the current period. S u b t r a c t i n g one from the o ther we get

PM = PM o + a ( V - - V o) = PM o + a ( V - - P M ~

which is the same as the recons t i tu ted d e m a n d funct ion (I5) of the tex t .

x L. Solari , Sur l'estimation du syst~me limCaire de d~penses par la mdthode du maximum de vraisemblance, Geneva Univers i ty , March I969.

2 The use of LES in in te rna t iona l t rade was first sugges ted b y R a m D a y a l in Sep t ember 197o in a paper Proiections o! Trade Network, s u b m i t t e d to the S tockho lm mee t ing of Pro jec t Link.

s A. P. B a t t e n et al., "A Medium Term Macro-Economic Model for the E E C " , European Economic Review, Vol. 7, Ams te rdam, 1976, pp. 645sqq.

' See footnotes on pp. I43-145.

x52 Ram D a y a l and Neeru Daya l

In the approach in COMET, ali and 9 are the unknown coefficients (9 being common to all sources of supply). But in Stone's LES, ali and M ~ (i. e., total committed or fixed imports of a product category by the importing country) are the unknowns.

Perhaps, Stone's LES is better, particularly because it offers the possibility of treating the base period imports as the committed imports and, therefore, treating M ~ as a known element. In that case only aii is unknown and this can be estimated even if very few observations on data are available. Furthermore, the COMET approach uses only the prices of the supplying country, perhaps because it is not straightforward, or feasible, to derive the price coefficients for the competing countries. But Stone's system provides the derived price coefficients not only for the supplying country but also for the competing countries.

Another variant of allocative approach recently used is the "S-Branch" system of Brown and Heien 1. This provides a generalization of the linear expenditure system and was developed in connection with the analysis of consumer expenditure within a country. An example, perhaps the only one, of its application to international trade, is an unpublished paper by Richard Berner *. He used it in the analysis of trade of EEC (6) countries and to estimate imports into each member country from the various sources of supply.

This approach involves the use of a highly complicated function as against the rather simple regression equation of Stone's LES. Berner found in his study that "supernumerary expenditure was not infrequently negative at the sample means, which violates the assumptions of the utility function from which the system is derived, and gives rise to negative income elasticities."

V. Effects of Tariff Changes on Prices

As already pointed out the trade creation and trade diversion effects of a tariff change or integration involve not only the effects of price changes on trade creation and diversion but also of tariff changes on prices. The second aspect is now taken up.

In some studies, this aspect is handled by making a simplifying assumption that the burden (or benefit) of a change in tariff is passed on

a Murray Brown, and Dale Heien, "The S-Branch Ut i l i ty Tree: A Generalization of the Linear Expenditure System", Econometrica, Vol. 40, New Haven, Conn., i972 , pp. 737 sqq.

t Richard Berner, Estimating Consumer Import Demand Equations, Board of Governors of the Federal Reserve System, x976, mimeo. - - Also see idem, An Empirical General Equilibrium Model o/ International Discrimination, Universi ty of Pennsylvania, x975, Ph.D. dissertation.


fully to the domestic market of the country altering the tariff 1. On this assumption, if Pm is the import price before an ad valorem tariff " T " is imposed, the price after the imposition of the tariff would be P* = P m (1 + T). The change in price is P~* -- Pm ~- T" Pro. The percentage change in price is Ioo (P*~--Pm)/Pm -~ Ioo T. If this ad valorem tariff is abolished, the price reverts to P, , , the change in price being (--) T . Pm and the per

$ �9 cent change being Ioo (Pm--Pm)/P m = -- IOO T/(1 + T). If the tariff is reduced, for example, from T to T/3, then the revised import price including the new tariff is P** = P* ( I - -2 T/3) = Pm (i + T) ( i - -2 T/3) "~ Pm (1 + T/3 ). The change in price as a result of this reduction is (Pm** -- P*) = Pro* (1 -- 2 T/3) -- P* = -- 2 T . P*/3 = -- (T -- T 2) 2 Pro/3 N ( _ ) 2 T �9 Pro/3. The per cent change in price as a result of tariff reduction would be xoo (P~* * * - - Pm)/P m which would be equal to either moo [P~m (1 - - 2 T/3) -- * * PT~/Pm = (-- 2 T/3) IOO; or approximately, it would equal [Pm (1 + T/3) -- Pm (1 + T)]/Pm (1 + T) = -- (2/3) [T/(1 + T)] IO0. 2

The assumption that the entire tariff change is passed on to the domestic consumer in the tariff changing country without any effect on the price of the supplying country, is often not valid. A more realistic probability is that the burden or benefit of tariff change would be shared between the importing and exporting countries, resulting in some change in the supply price as well s. In such a case, the per cent change in the import price inclusive of tariff in the tariff-changing country is worked out like this: In period I, when no tariff is in force, the cif price (excluding tariff), Pml, equals the domestic wholesale price at the importer 's level, Pro, the subscript i denoting the first period. In period 2, a tariff rate T is imposed and supposing that its burden goes entirely to the domestic market without any change in the cif import price, then Pro*2 = Pm2

(1 + T) = Pro1 (1 + T). In period 3, the tariff is cut by 2 T/3 and it may be assumed that one-third of this cut is shared by the exporters. Then, P m = Pro2 (1 + 2 T/9 ) and P ~ = Pro3 (1 + T/3) = Pro2 (1 + 2 T/9 ) (1 + T/3) ~- Pro2 (1 + 5 T/9), ignoring the T ~ term. The per cent change in P* is IOO ( P ~ * * = - - Pm,)/Pm2 IOO (4 T/9)/(1 + T). The per cent change in the supply price can also be similarly worked out.

x For example, Robert M. Stern "The U.S. Tariff and the Efficiency of the U.S. Econ- omy", Tke American Economic Review, Vol. 54, x964, Papers and Proceedings, pp. 459 sqq. - - Officer and Hurtubise, op. cir.

2 More precisely, it would workout to [Pro (1 + T) (1 - - 2T/3) - - Pm (1 + T)]/P m (1 + T) = [ - - ( 2 T / 3 ) ( 1 - - T ) / ( 1 + T)] xoo.

s For example, Bela Balassa and Mordechai E. Kreinin, "Trade Liberalization under the 'Kennedy Round': The Static Effects", Tke Review o/Economics and Statistics, Vol. 49,

I967, pp. I25 sqq.

154 Ram D a y a l and Nee ru D a y a l

Instead of this ad hoc sharing of the burden or benefit between trading partners, a more systematic way of determining the effect of tariff changes on prices has been pioneered, perhaps, by Homer 1. His s tudy of the Australian exports related to determining the influence of a change in the exchange rate on exports, but since devaluation or revaluation can be viewed as being equivalent to the corresponding change in tariff on all imports and similar taxes or subsidies on the exports of the country, his method is directly applicable to determining the effect of tariff changes on prices. Homer 's method, slightly modified to suit the analysis of imports rather than exports, starts from the fact that imports into country A from country B are equal to the exports of country B to country A. That is M = X. Differentiating both sides with respect to exchange rate r, we get

(dM/dPm*)" (dPm*/dr) = (dX/dPm)" (dPm/dr)

where P~* = import price including tariff in the importing country 's currency and Pm is the corresponding supply price in the exporting country's currency. This can be written in the form of elasticities as

(I7) Em'P*m' Ep*m'r = Ex' Pm " E p m ' r

where E m is the elasticity of import demand with respect to the , p *

import price including tariff, the other terms being similarly defined. Now, P* is equal to Pm multip]ied by the exchange rate r, assuming the absence of tariff. That is P* = Pm " r. Differentiating this with respect to exchange rate, we get (dP*/dr) �9 r /P* = [(dPm/dr) �9 r/P~] + 1. In terms of elasticities, it will be

(18) Ep~m, r = Epm,r -] t- I

Substituting this in the preceding relationship, we get

(19)

and

(20)

E p ~ , r ----- Ex, pm/(Ex, p m - - Era, p.m)

Epm,r = __ Em, p*/(Em, v* ~ -- Ex, pm)

This shows that the change in the import price in the currency of the importing country (i. e., Pro*) and the change in the supply price in the

* F. B. Homer, "Elasticity of Demand for the Exports of a Single Country", The Review o/Economics and Sta2istics, Vol. 34, 1952, pp. 326 sqq.

Trade Creation and Trade Diversion x55

exporting country's currency, as a result of a change in the exchange rate would depend upon the import demand and export supply elasticities.

When a change in tariff T rather than a change in the exchange rate is being considered, the expression similar to (17) would be

(21) Era, p , m �9 Ep,m, T = Ex, pm �9 E p m , T

where P* is inclusive of tariff, and since no change in exchange rate is being considered, P* and Pm can be in the same currency or in the currencies of the importing and exporting countries respectively. In the same way, the expression similar to (18) can be arrived at from the relation Pro* = Pm (1 + T) which on differentiation with respect to T gives

(22) E p ~ , T = E P m , T -~- T/(1 + T)

This on being substituted into (21) gives expressions similar to (19) and (20):

E=.p. T

(23) E p m, T = E x 'Pm - - Era' P*m ( l + T)

E~, Pm T (24) Ep.,T = E~, P m - - Era' P*m (1 + T)

In this way, changes in import price (inclusive of tariff) and in the supply price, as a result of a change in tariff, are determined in terms of the import demand and export supply elasticities.

Homer and several other analysts have believed that the import demand and export supply elasticities do not lend themselves to empirical estimation easily, and that these should be indirectly derived from the domestic demand and supply elasticities which are more readily measur- able 1. Proceeding from the identity that imports (M) equal domestic demand (H*) minus domestic supply (0"), i .e., M = H* -- 0", and differentiating it with respect to Pro*, it is easily seen that

(25) Era, p* ~ = Eh. 'Pro" H*/M -- E0. , p . " 0 * / i

1 For example, C. E. Ferguson and Metodey Polasek, "The Elasticity of Import Demand for Raw Apparel Wool in the United States", Econometrica, Vol. 3o, x962, pp. 67o sqq. - - Vernon M. Malach, "Elasticity of Demand for Canadian Exports" , The Review o/Economics and Statistics, Vol. 39, x957, PP. 23 sqq.

I56 R a m Dayal and N e e r u Dayal

where Eh*, p~ and E0.. p* are the domestic demand and supply elasticities

with respect to price inclusive of tariff (or, in other words, domestic price). When imports from a single country are to be considered, while there are third sources of supply, the identity would be M = H* -- 0* -- S*, where S* is supplies (imports) from the third sources. The relation at (25) would become

(26) E m ' P*m ~- (Eh* ' Pro* �9 H*/M) - - ( E 0 , , pro, �9 0*/M) -- (Es, 'Pro* " S * / M )

In the same way, the export supply elasticity is derived from the domestic demand and supply elasticities of the exporting country.

( 2 7 ) E x ' Pln : - - (Eh, Pm" H/X) + (E0, Pm" 0/X) -- (Es, Pm" S/X)

where 0 is the domestic output in the exporting country, H the domestic demand in the exporting country and S the supplies (i.e., exports) from the exporting country to the third countries, and X are the exports to the particular importing country under consideration.

The import demand and export supply elasticities at (26) and (27) can be substituted into (23) and (24) to obtain the effect of a tariff change on the import price (including tariff) of the importing country and the supply price of the exporting country.

Since Homer put forth this approach, it has been used by several analysts. For example, Floyd I used it in analysing the problem of overvaluation of the dollar. Fortune 2 used it in his study of the effects of the Kennedy Round tariff reductions on the Canadian imports from the United States in respect of refrigerators, washing machines, television sets etc.

However, some of the formulas can, perhaps, be improved upon. To give an example of the possible improvements, let us derive the relationships of the previous section in a more formal way. Let the import demand of the importing country and the export supply of the exporting country be represented by the functions

(28) M = f (P*) and X : f (Pro)

The logarithmic form of these functions is

Log M = Era' Pro* log P* and Log X = Ex, Pm log Pm

1 John E. Floyd, "The Overvaluation of the Dollar, A Note on Internat ional Price Mechanism", The American Economic Review, Vol. 55, I965, pp. 95 sqq.

s j . Neill Fortune, "Measurement of Tariff Elasticities", Applied Economics, Vol. 3, Oxford, New York, x97x, pp. x9 sqq.


Since import demand equals export supply, we have

Era' Pro* log Pro* = Ex, Pm log Pm

which on differentiation with respect to tariff becomes

Era' Pro* " Epm*' T = Ex, Pm " EPm' T

This is (21) from which (23) and (24), relating to the effect of tariff on Pm and Pro*, are derived. This shows that the whole derivation of the previous section is based on the highly simplified and inadequate import demand and export supply functions.

But it needs hardly any mention that the import demand and export supply functions are not so simple in the real world. Introducing a touch of reality in the import demand function at least, we get

(29) i = f ( P o , Pm, Y) and X = f ( P m )

where Y is income, Pd is the price of the domestic product in the importing country and is similar to P*. Writing the logarithmic form of the above two functions and differentiating with respect to tariff, we get

(30) (Era' Pd " EPd' T) "27 (Era, Pm " Epm' T) + (Era, y " Ey, T)

= (Ex' Pro" Epm' T)

From this the elasticity of export price with respect to tariff would be

(Em, y �9 Ey, T) + Era' Pd " 1 27 T

(31) Epm,T = Ex, p m - - Era, pro - - Em, Pd

This is different from (23) even if it is assumed that a tariff change has no effect on Y and Ey, T = 0.

All the same, for obtaining approximate results, this approach can stand in good stead for determining the effect of tariff changes on prices, provided new formulas based on more realistic specifications of the import demand and export supply functions are developed, in the way just elaborated, in place of the conventional ones. In particular, when domestic demand and supply elasticities are already roughly known from other sources, this approach can prove quite helpful.


VI. Integrated Model Approach

Despite the workability of the approach of the previous section in many circumstances, it remains piecemeal and uncoordinated, relying on informal indirect derivation of relationships rather than taking advantage of the formal and systematic specification of the various inter-relationships and their feedback mechanism 1, characteristic of the full integrated models. The ideal thing would be to undertake an integrated model, if the resources so permit. The integrated approach traces out, one by one, all the possible actions and reactions that take place in the international market, following changes in tariff by one or more countries. I t then interlinks the individual actions and reactions into a single whole system, so that whenever any one part, such as tariff, undergoes a change, the new and mutually consistent position of all the other parts including trade creation, trade diversion, production, consumption and prices, is simul- taneously determined. The integrated approach captures the feedback effects in addition to the direct effects of variables on each other S .

When a country reduces its tariff on imports from another country or a group of countries, the following sequence of reactions might ensue:

I. The immediate consequence would be a narrower margin between the cif import price, Pm (which does not include tariff) and the price an importer charges to the domestic wholesalers, P~*, which includes tariff. In the first instance, the narrowing of the margin results from a fall in Pro*.

2 (a). The consumer response in the importing country to a fall in the prices of the imported product results in trade creation and trade diversion, as explained in an earlier section. If the trade creating effect is strong and if imports are not a close substitute of the domestic product so that the substitution (trade diverting) effect is weak, then whereas imports may increase as a result of both the trade creating and trade diverting effects of a price fall, the domestic producers may not be adversely affected, as their loss due to some diversion of consumer demand towards imports is offset by their share of the gain due to trade creation.

t It, however, does take into account some feedback effects. These are taken care of by the various substitutions done in the previous section to arrive at the final formulas.

z The importance of the integrated approach is illustrated in the study by Johnston and Henderson, op. cir. By relating imports with domestic consumption and changes in stocks, they came to the conclusion that the British import surcharge of October x964 had no effect on British imports. But when they took into account the feedback effect of changes in imports on domestic consumption, they concluded that the import surcharge had the restricting effect on imports to the extent of s xoo million within a few months.


2 (b). But if imports are a close substitute of the domestic product the trade diverting effect may be strong, and whereas imports may tend to increase even more than in 2 (a), the domestic producers may be adversely affected. The demand and price for their product may tend to fall. Their response to the situation may depend on the cost conditions in the industry:

(i) If the domestic industry is operating at constant costs, that is, it has infinite elasticity of supply, the producers' costs and hence prices would remain largely unchanged when domestic production is reduced, and so the trade diverting tendency on the part of the consumers would be fully reflected in an increased import demand.

(ii) If the domestic industry operates under increasing cost conditions, a cut in its output following reduced consumer demand and market price for its product, would result in lower unit costs. The industry would be able to afford a lower price and thereby reduce its competitive disadvantage in relation to the imported product. The trade diversion towards imports would be cut short. The more rapidly do the costs increase with higher output (or decrease with lower output) the lower is the elasticity of supply and the less would be the diversion towards imports.

3 (a). The conditions of supply in the exporting country are equally important. If the exporting country's industry is operating at constant costs (i.e., infinite supply elasticity) and can meet the additional demand from the importing country without raising the supply price, the additional demand for its product in the importing country would be fully reflected in a larger trade flow. But if the industry in the exporting country is operating under increasing costs and can offer additional supplies only at a higher price, P~ will rise; P* would also go up from the lower level it reached after the tariff reduction; imports would not increase to the extent they tended to do following the reduction in tariff. The more rapidly the cost increases, the lower would be the supply elasticity and the smaller would be the increase in trade flow.

3 (b). As the export price of the exporting country increases, its domestic price would also go up. This would influence the domestic demand in the supplying country. If the domestic consumers show a strong response and curtail their purchases, the corresponding quantities would become available for export with, at the same time, a moderation in the initial rise in the supply price. Thus a high elasticity of domestic demand in the exporting country could partly or wholly offset the adverse effect of the increasing cost conditions in the industry on the trade flow.

z6o R a m D a y a l and N e e r u D a y a l

4. The demand and supply reactions in the importing and exporting countries, following the initial fall in Pro* as a result of tariff reduction, would bring about a readjustment in Pm and Pro*. This would set in motion a fresh cycle of reactions in the same way as outlined above. There would thus be an iterative chain of actions and reactions until the situation is stabilized. While Pm and P* would readjust again and again, the relationships between them would always be governed by the new reduced level of tariff. That is Pro* = P m (1 + T), where T is the new level of tariff.

I t can be shown that these iterative chains of actions and reactions are taken into account by the inversion of the matrix of coefficients of the endogenous variables in an integrated model and multiplying the inverted matrix with the vector of exogenous variables 1. What is needed is to have a model containing not only the import and export equations but also the demand and supply functions, the price determining mechanism and the necessary identities to link the different parts together into a consistent framework in such a way that the number of equations including identities is equal to the number of endogenous variables so that the matrix of coefficients of the endogenous variables can be inverted and a unique solution of the model can be obtained ~.

Such a model for 3 countries, as for example, the member country (i), the partner country (j) and the third country (k) is outlined below. The various equations are for country i only, and there would be the same equations for the other two countries also.

(I) V~ ----- v~ (v~(_~), Is (_~))

(za) V~ ---- V~ (t p)

(2) Vi = Vi (V[, P~, P~ (-1), Mi)

(3) Ii ---- Ii (Vi , P ~ , I n t o ) , Mi)

(4) Ci = Ca (Vi , P~) (5) M~ = Mj~ (Yi*, Pmii, Pmji, Pmki)

capacity output based on capital formation

capacity output based on a trend through output peaks

actual production

investment

consumption

imports from j in current value

1 Government of New Zealand, Depar tment of Statistics, Iuter-Industry Study o/ the New Zealand Economy, z959--6o, P. 4 : A Description o/the Input-Output Tables and System, Wellington, x967 , pp. zz sq.

z If the model has non-linear elements, the solution would be obtained by i teration rather than straight inversion of the matr ix. The basic theory, however, remains the same. The solution of the linear sys tem by matr ix inversion is only a special case of the general solution of a non-linear system through iterative procedures. Tha t is why the inversion of the matr ix can be regarded as a special way, applicable to linear sys tems only, of taking into account the iterative chain of actions and reactions.

Trade Creation and Trade Diversion x6I

(6) M~ = MS (Y*, P~i, Pmji, Pm~)

(7) Mi~ = Mi~ (Y*, Pmii, Pmji , Pmki)

(8) Mi* =Mj* +Mk*

(9) E* = M i ; + M ~ 1

(IO) Pmji = Pmji (Pej, Ti, ERi)

( I I ) Pmki = Pmki (Pek, T i , E R i )

(i2) Pn.i = P ~ ( I3) eel = Pei (Pdi)

(14) Mji * = M j i / P m i i

(15) Mki * = Mki/Pmva

(16) M i = Mji + Mki

(I7) E~ = E*/Pei

(18) V i = Ci + Ii + Ei -- Mi

(19) Si = V i - - C t (20) F* = i * - - E *

(21) Yi = Vi - - E i + Mi

(22) Y* = Yi " Pdi

imports from k in current value

absorption from domestic production in current value

total imports from abroad in current value

total exports of the country in current value

import price of imports from country j to country i import price of imports from country k to country i price of domestic supplies

export price of country i imports from j to i in constant value imports from k to i in constant value total imports from abroad in constant value total exports to other countries in constant value

income-expenditure identity; equilibrium for determining domestic price, Pm

savings identity

net inflow of foreign capital

domestic disappearance in constant value

domestic disappearance in current value

These are 22 equations with an equal number of endogenous variables for country i. These endogenous variables are defined above against each of the 22 equations. All other variables are exogenous and these are

T = tariff

Int ---- interest rate

1 The equation for M~ would appear in the set for country j and the equation for M~k would appear in the set for country k.

WeltwirtsehaftliehesArchiv Bd. CXlII. i i


ER = exchange rate

t = time t p = time (i. e., year) of peak production

In addition, there are a number of lagged endogenous variables.

The various functions and identities are self-explanatory. I t may, however, be pointed out that the purpose has been merely to illustrate the broad approach, and a proper specification of the functions would need to be given more attention to suit individual situations and geographical units. There would be a similar set of equations and identities for country j and country k.

Equations (5), (6) and (7), relating to imports from different sources and the domestic sources of supply are specified in current value terms, so that Stone's linear expenditure system approach can be used in estimating these equations. In this approach, the domestic activity variable has to be total domestic disappearance in current value terms, Y*. The idendity Yi* = Mj~ + M~ + Mi* 1 is automatically preserved by the use of Stone's approach. There is, therefore, no need to introduce this explicitly as a separate identity in the model. In this way, the problem of one equation being in excess of the number of endogenous variables is avoided.

In this model, the general price level is determined at the level which would bring about a balance between output and expenditure. As the present purpose is not to forecast prices but rather to use them as an intermediate stage in the determination of the effect of tariff changes on trade flows, the approach adopted in the model seems to be all right and has the advantage of simplicity.

The alternative approach is to introduce a specific equation or equations for determining domestic prices rather than depending on their equilibrat- ing role. The determination of the general domestic price level is a rather difficult task. There are two dominant theories of pricing: (i) the supply and demand competitive mechanism; and (ii) the target return, full cost pricing mechanism. The monetary determinants add further complexity to the task. Some ideas on approaches to price determining functions in models of trade and development are given in "Models of Trade and Development: A Theoretical Review"2.

As exports of a country (equation (9)) are derived by summing up the imports by others from this country, global imports would necessarily

t Ram Dayal, Models o] Trade and Development: A Theoretical Review, Swiss Federal Institute of Technology, Centre for Economic Research, Research Monographs, N.S., Vol. I3,

Zurich, I975.


equal global exports, and so it is not necessary to specify this condition as a separate identity.

Some of the variables are specified both in current and constant value terms. The model would generate these variables in both current and constant values, and their prices would also be determined by the model. As for the other variables, they could be generated in either constant or current value terms, depending upon whether the data used are in current or constant values. Their prices are not generated by the model. If all current value data are used, the model would remain linear. Otherwise, there would be non-linear elements.

When a country i revises its tariff on imports from country j, the import price Pmji would change, as tariff is an explanatory variable in the equation for Pmii. A change in Pmji would influence the imports of country i not only from country j but from all the sources of supply including the domestic source. The resulting change in total imports of country i would alter GDP through the income-expenditure identity, and the domestic price would also change because it is related to the level at which the income-expenditure equilibrium is effected. The change in GDP as also the domestic price would influence variables like consumption, investment, savings and production. Furthermore, a change in the imports of country i would mean a change in the exports of its trading partners and the consequential changes in their GDP, consumption, investment, production, domestic and export prices. Changes in their export prices would, in turn, affect the import prices of country i and this will set forth another chain of actions. Similarly, changes in their GDP and its components would affect the exports of country i. In this way, iterative chains of actions and reactions would take place, as explained in the beginning of this section, and the above model is well suited to capture all these initial and secondary (feedback) effects.

There are two ways of determining the trade creation and trade diversion effects. According to the first approach, the model may be solved for a given change in the tariff of one country on imports from another country. The solution of the model would give new levels of import prices, Pmji, Pm~i and Pr~i. The changes in these prices brought about by the tariff change can thus be determined. The trade creation and trade diversion effects of a change in each of these prices can be worked out from the equations at (5), (6) and (7) of the integrated model by using the formulas for trade creation and diversion given in an earlier section.

Alternatively, equations (5), (6) and (7), after being statistically estimated, can be used to write down the expressions for trade creation and trade diversion. In these expressions, the coefficients would be

I64 Ram Dayal and Neeru Dayal

known, but changes in prices and imports would still be unknown. These expressions for trade creation and trade diversions would replace the trade flow equations (5), (6) and (7) in the whole model. The model can then be solved for a given change in tariff. The solution would generate trade creation and trade diversion along with other variables. This approach would, however, involve non-linearities and differentials, which would make the solution of the model a rather tough task.

Appendix

Feasibility of Empirical Analysis Based on the Integrated Model

The model outlined above, like any other involving analysis of bilateral trade flows, is bound to require a considerable amount of manpower and time, depending on the number of geographical units in which the world may be divided and the number of product categories which may be taken up for analysis. Otherwise, from the econometric point of view, i t is quite straightforward. I t is a direct combination of the usual models for individual geographical units (e. g., a country or a continent), which have been built up by many individuals or institutions such as UNCTAD, IMF, Project Link led by Klein, the Cleveland Systems Research Group led by Mesarovic, Economic Commission for Europe, OECD, etc. One of the specialities of the model outlined above is tha t the linking of models for different geographical units into a global framework is done through a network of equations for bilateral flows, which are estimated with the help of an allocative proceduresimilar to the Linear Expenditure System, thereby overcoming the problem of inconsistency between the number of equations and the endogenous variables while at the same t ime fully taking into account the impact of prices of the importing, exporting and competing countries on trade flows. Another speciality of this model is the dovetailing of the newly devised mechanism for estimating trade creation and trade diversion, the two concepts which have themselves been extended and made more meaningful as compared with the original ones given by Viner two and a half decades ago.

The main problem likely to arise is tha t relating to data. The main variables for which time series are required are GDP, output, consumption, investment, exports, imports, bilateral trade flows, domestic prices, export prices, import prices, exchange rates, interest rates and tariffs.

So far as the broad aggregates of these variables are concerned, da ta are easily available for most of them in the UN publications on national accounts statistics and similar publications of the OECD and the UN regional economic and social commissions, and the IMF publications on monetary, financial and direction of trade statistics.

The only difficulty about data, which can arise so far as the aggregative analysis is concerned, relates to tariffs. But the position is not too discouraging. Individual country tariffs give year to year tariff rates according to tariff classification, mainly BTN. The concordance between BTN (or other tariff classifications) and SITC is generally available. The GATT has averaged the tariff line rates to the BTN-heading level (4-digit) for individual countries and has published them in the first volume of their Tariff Study. This volume is called Summary by BTBI Headings. Similarly, it

Trade Creation and Trade Diversion z 6 5

h a s ave r aged tar i ffs for t he r aw mate r ia l s , s e m i - m a n u f a c t u r e s a n d m a n u f a c t u r e s a n d for n o n - a g r i c u l t u r a l p r o d u c t s as a whole. T hese ave r ages h a v e been p u b l i s h e d in V o l u m e i i ( S u m m a r y b y I n d u s t r i a l P r o d u c t Categories) of t h e Tar i f f S t u d y .

I t m a y also be po i n t ed ou t t h a t t h e i n t e g r a t e d mode l o u t l i n e d above uses t h e tar i ff r a t e no t as a ful l e x p l a n a t o r y var iable , b u t o n l y as a m a r k - u p to re la te i m p o r t pr ices to expo r t pr ices of t he t r a d i n g pa r tne r s . Since t he effects of pr ices on b i l a t e ra l t r a d e flows are o n l y ind i rec t ly e s t i m a t e d w i t h t he he lp of t h e LES , i t is n o t n e c e s s a r y to h a v e a n n u m t i m e series on tar i f f ra tes . I t is t h e a d v a n t a g e of t h i s m o d e l t h a t i t does p rov ide t h e d i rec t a n d ind i rec t effects of ta r i f f c h a n g e s on pr ices a n d of pr ices on t r a d e flows x, w i t h o u t r equ i r i ng a t i m e series on t h e ta r i f f var iab le .

W h e n i t comes to a n a l y s i n g t h e effects of ta r i f f c h a n g e s (and i ts b r e a k - u p in to t r ade c rea t ion a n d t r ade diversion) for i n d i v i d u a l g roups , s u b - g r o u p s or n a r r o w e r p r o d u c t categories , t he d a t a p rob l em becomes qu i t e difficult . Un l e s s t h e a n a l y s i s is res t r i c ted to o n l y a v e r y few p r o d u c t categories , t h e job ge t s b e y o n d t h e m e a n s of a n y i n d i v i d u a l researcher to hand le , a n d needs resources ava i l ab l e to g roups a n d in s t i t u t i ons .

I n general , t h e d a t a b y p r o d u c t ca tegor ies a re ava i l ab l e for t h e deve loped coun - t r ies a n d some of t h e deve lop ing count r ies , a t l eas t in t h e e l e m e n t a r y fo rm. T h e s e are, of course, t h e coun t r i e s for wh i ch t h o a n a l y s i s of t r a d e c rea t ion a n d t r a d e d ivers ion h a s d r a w n genu ine a t t en t i on .

Wor ld t r ade ma t r i c e s b y regions, or even b y count r ies , for i n d i v i d u a l p r o d u c t categories , s u b - g r o u p s a n d groups , d iv i s ions a n d sec t ions , c an be o b t a i n e d f rom t h e UN.

To ob t a in t h e co r r e spond ing d a t a for tariffs , i m p o r t a n d e x p o r t pr ices, t h e ava i l ab i l i ty of i n f o r m a t i o n on q u a n t i t y , va l ue a n d u n i t v a l u e of t r a d e b y de ta i l ed ca tegor ies accord ing to B T N as well as SITC, t o g e t h e r w i th t h e conco rdances b e t w e e n t h e two classif icat ions, wou ld serve t h e purpose .

I t appea r s s t h a t t h e bas i s ex i s t s for c o m p i l i n g a r e a s o n a b l y c o m p a r a b l e d a t a series for impor t s , expor ts , i m p o r t prices, e x p o r t pr ices a n d tar i f f r a t e s for a n i nd iv idua l p r o d u c t ca t ego ry one m a y like to u n d e r t a k e for t h e a n a l y s i s of t r a d e c rea t ion a n d t r a d e d ivers ion . I t m a y be s t ressed t h a t a v e r y r o u g h c o m p a r a b i l i t y is enough , a n d a r igorous c o m p a r a b i l i t y is n o t e s sen t i a l for t h e p r e s e n t pu rpose .

T h e use of i m p o r t a n d expo r t u n i t va l ue s in p lace of i m p o r t a n d e x p o r t pr ices h a s s o m e t i m e s been cri t icized 8. Bu t , in fact , i m p o r t (and expor t ) u n i t v a l u e s h a v e t h e a d v a n t a g e of be ing ava i l ab le a t t h e s a m e de ta i l ed level as t h e s t a t i s t i c s on q u a n t i t y of impor t s . A t t he de ta i l ed i t e m level, t h e y are, in fu l l sense, a q u a n t i t y - we igh ted ave rage pr ice of al l t r a n s a c t i o n s (i. e., impor t s ) of t h a t i t em, a n d so t h e y effect ively m e e t t h e genera l c r i t ic i sm of t h e pr ice d a t a t h a t t h e y re la te to a few or m o d a l q u o t a t i o n s w i t h o u t r egard to t h e r e l e v a n t q u a n t i t i e s invo lved .

I t seems t h a t t h e d a t a s i t u a t i o n for d o m e s t i c pr ices is less hopefu l . D o m e s t i c pr ices accord ing to t h e t r ade a n d tar i ff n o m e n c l a t u r e s a re gene ra l l y n o t ava i lab le , excep t for Sweden, F i n l a n d , N o r w a y a n d Aus t r i a . P r o d u c e r a n d / o r wholesa le pr ices

t Tha t the model would capture the direct and indirect effects of tariff changes is explained on p. x63. In the reduced form of the model, the equation for each endogenous variable would have a coefficient indicating the effect (direct + indirect) of tariff.

2 See the table on availability of s tat is t ics for a sample of countries at the end of this appendix.

�9 Kravis and Lipsey, op. cir.

I66 Ram Dayal and Neeru Dayal

according to the industrial classifications are available for most countries. :But it seems difficult to match them into trade or tariff categories in a majori ty of cases, though it may be feasible to do so for certain product categories. If the industrial categories are selected for analysis, the matching of trade/tariff i tems into the industrial categories would be possible in many cases, such as 4-digit industry and 5-digit product class levels of SIC for the United States, ISIC groups for Sweden, Finland and South Africa, and the SIC industry and sub-industry levels /or the United Kingdom. This is the general si tuation; the data position for selected individual product categories may be more hopeful, as for example, metals.

I t seems necessary to clarify tha t a concordance between domestic and import prices is not as necessary as tha t between import prices and import quantities. Imports are regarded as being considerably heterogeneous from the domestic products, even though they may belong to the comparable classificatory groups. Im- ports compete with domestic product in consumer and entrepreneurial demand not entirely through direct substitution but through competing claims on the consumer dollar and the entrepreneurial productive resources. The latter competit ion may often be no less important than the former. As such, a very rough concordance between domestic and import prices would serve the purpose.

There is also the possibility of using export uni t values to represent domestic prices, as the export unit values are generally available for the same classificatory groups as the import unit values. I t is true tha t in any product category, the bundle of exportables would be considerably different from the bundle of domestic consumption, but this is by no means a crucial point when it is borne in mind tha t imports would be considerably heterogeneous from domestic production and consumption.

Two other variables required in the model outlined above are production and domestic disappearance (or consumption and investment separately). In some cases, production data may be available and domestic disappearance may be derived by its identi ty with production and trade. In other cases, it may be the other way round. So far as the primary commodities are concerned, including metals, minerals, oil and agricultural products, it is not difficult to obtain information on production and domestic disappearance for different countries and regions. This information is available with the FAO, UNCTAD, World Bank, IMF, individual commodity bodies and their publications.

Keeping in mind tha t only very rough estimates of production and consumption would do, in view of the heterogeneity of the imported and domestic products, i t would appear tha t information would be available for the pas t IO years or more for the 4-digit trade categories for the United States, Sweden, Finland, Norway and possibly Japan and at a more aggregative level for Australia and possibly New Zealand. For other countries, in the sample, estimates according to trade categories are generally not available, though the possibility of obtaining the data for individual categories cannot be ruled out.

Sufficient scope seems to exist for undertaking the analysis based on the model for selected product categories, in addition to the analysis for the broad aggregates which is quite feasible on all counts. The model may, however, have to be modified here and there to suit the availability of data for a particular product category. A framework of analysis, like the one presented here, while it should be realistic in its requirements of data, need not be tailored too t ight ly to the availability of da ta just a t the present point of time. Rapid strides are being made by Governments, in cooperation with the United Nations and its Agencies, towards collecting statis-

Tra de Creat ion a nd T r a d e Divers ion I67

t i c a l i n f o r m a t i o n in i n c r e a s i n g d e t a i l a n d s e c u r i n g i t s c o m p a r a b i l i t y a t t h e n a t i o n a l

a n d i n t e r n a t i o n a l l eve ls . C o n s e q u e n t l y , m o r e a n d m o r e r e f i n e m e n t s a n d d i s a g g r e g a -

t i o n in t h e a n a l y t i c a l w o r k a r e b e i n g m a d e p o s s i b l e d a y b y d a y . I t is h o p e d t h a t

t h e f r a m e w o r k of a n a l y s i s o u t l i n e d a b o v e w o u l d e n c o u n t e r less a n d less d a t a p r o b -

l e m s in t h e p e r i o d a h e a d 1.

Availability o/Statistics

Information on Country

and value of imports I domestic prices I production quantity

from x96I, at the 5-digit tariff line from x96r, wholesale price index annually for 400 4-digit and r,xco 5- (TSUS) level; from I964, at the aCCOrding to the xo-digit detailed digit product classes of SIC; for the 7-digit TSUS-A level; rough con- specification and for 4-digit indus- census years (z958, I963, r967 etc.) at cordanee between TSUS and BTN" try and 5-digit product class the 7-digit SIC level; concordances axe headings is available; data are level of SIC; consumer price index available for each of the years to relate also available according to SITC by expenditure classes produetion to trade and vice versa

USA

Japan

Sweden

Norway

1

from I96x, according to the SITC; concordance with tariff nomen- clature since I963

from i966, according to the SITC- based tariff line level; for I963 to 66, aeeordtng to SITC; for ~96I to 63, a different arrangement of items but the description of items appears to be much the same as for the subsequent period

from x96x, according to the 7-digit tariff line level of the Swedish Customs Tariff (BTN-based) ; also according to SITC

from i96 x, according to the 7-digit BTN-based tariff line level; also according to SITC

from ~965, producer price index for x8 industries; from x96x onwards, wholesale price index for Iz groups of commodities

from i96x , producer prices at the SIC industry and sub-indnstry level from data for xx,oco (previously 7,000) items

from x964, producer price index for ISIC groups as well as for Swedish Customs tariff items represented in the producer price index; wholesale price index for I5 groups and 33 subgroups; consumer price index according to expenditure classes

from i96i , ex-factory prices for a substantial proportion of corn- modifies specified in the annual industrial statistics which are alas- sifted according to BTN; wholesale price index for all divisions and important groups of SITC; consumer price index for a major- ity of SN'A groups

annually according to the 6-digit Jap- anese SIC; the trade data can, in principle, be arranged in accordance with the 3- or 4-digit groups of SIC

for the census years (x963, x968j etc.), gross output by minimum list heading ~3-digit) of the U.K. SIC; production for individual commodities within each heading is also reported; data for about a thousand selected products are collected monthly for the calcula- tion of the index of industrial production; trade data can be approximately arranged according to the 3-digit groupings of SIC

annually from x959 according to the commodity list incorporated in the BTN-based tariff; conversion to SITC is possible

from 196i , according to a classification based on BTN" which is in large part identical with the import list, number of products being over 3,500

continued

Some of the more general difficulties in bui lding up maeroeeonomie models for devel -

oping countries are discussed b y Arun Shourie, " T h e Use of Maero-Eeonomie Regression

Models of Developing Countries for Forecas ts and Policy Prescript ion, Some Reflections on

Cm'rent Prac t ice" , Oxford Economic Papers, N. S., Vol. 24, x972, pp. x sqq. - - This cr i t ic ism

has been answered b y V. K. Sast ry , " T h e Use of Maeroeeonomie Regression Models of

Developing Countries, A C o m m e n t " , ibid., Vol. z7, x975) PP. 156 sqq.

168

continued

R a m D a y a l a n d N e e r u D a y a l

Country I n f o r m a t i o n on

quantity and value of imports I domestic prices production

Finland

Austria

Australia

South Africa

from 196r, according to the Fin- nlsh Customs Tariff line level (BThr-based); also according to SITC

from r961, according to the BTN- based customs tariff line level; also according to SITC

from 1965, according to the Aus- tralian customs tariff line level (BTN-based) and according to a more detailed statistical classification; for I96I--64, according to the previous customs tariff line level, but rearranged according to the subsequent classification as far as possible

according to SITC; s concordance with tariff lines up to i963 and from i969 onwards, and with BTN headings for 1965--68

New from i961 , at the tariff line level; Zealand also according to SITC

from I961, producer price index and wholesale price index on ISIC basis and at the SITC 4- digit level (selected products) and x-digit level divisions; consumer price index according to the usual expenditure classes and from I967 according to SNA groups

wholesale price index for about 2co items in the BTN chapters 25--99

from 196I , consumer price index for usual expenditure classes; wholesale price index not available for much of the period since I961

from i96I , wholesale price index at the major group level of ISIC in most cases and at the division level in other cases

from i964, according to BTN and frorr 1968, according to the Joint Nordic Commodity Classification (BTN + 2 additional digits); concordance with trade statistics can, in most cases, be established

output by commodities and groups of commodities is available on a monthly and yearly basis; concordance with trade statistics is possible, but it would involve considerable effort

from I967--68 for 3,5oo products or : more; concordance with trade data is possible at broad levels only

for every year according to ISIC; concordance with SITC is available

from I96i , wholesale prme index / output is available from the annual for 40 groups of industries / census for 11o industries classified

according to the New Zealand SIC, which generally follows ISIC, and for major products within each industry; cOncordance with trade statistics is possible, at least at broad levels

Note: The countries of EEC (6) are not covered, because it is understood that generally fuller information is available for them than for most other countries.

Z u s a m m e n f a s s u n g : H a n d e l s s c h a f f u n g u n d H a n d e l s u m l e n k u n g : N e u e K o n - z e p t e , n e u e M e t h o d e n d e r M e s s u n g . - - I n d e n l e t z t e n f i i n f z e h n J a h r e n s i n d v i e l e V e r s u c h e g e m a c h t w o r d e n , d i e h a n d e l s s c h a f f e n d e n u n d d i e h a n d e l s u m l e n k e n d e n W i r k u n g e n e i n e r Z o l l u n i o n z u m e s s e n , b e s o n d e r s f t i r d i e E u r o p R i s c h e W i r t s c h a f t s -

g e m e i n s c h a f t u n d d i e E u r o p i i i s c h e F r e i h a n d e l s a s s o z i a t i o n . A b e r k a n m e i n e r y o n i h n e n k a n n a l s b e f r i e d i g e n d a n g e s e h e n w e r d e n . E i n w e s e n t l i c h e r G r u n d h i e r f i i r , d e r n i c h t a l l g e m e i n e r k a n n t w i r d , i s t v i e l l e i c h t , d a b d i e v o r h e r r s c h e n d e n K o n z e p t e d e r

H a n d e l s s c h a f f u n g u n d H a n d e l s u m l e n k u n g M i i n g e l a u f w e i s e n u n d s i c h f t i r s t a t i s t i - s c h e M e s s u n g e n n i c h t e i g n e n .

E s i s t d e s h a l b e r f o r d e r l i c h , K o n z e p t e z u e n t w i c k e l n , d i e f i i r d i e H a n d e l s - b z w . Z a h l u n g s b i l a n z p r o b l e m e r e l e v a n t s i n d , a b e r a u c h a n g e p a B t w e r d e n k 6 n n e n , n m d e m K r i t e r i u m d e r W e l t w o h l f a h r t z u g e n i i g e n . Z w e i t e n s s o l l t e n d i e K o n z e p t e so g e s t a l t e t s e in , d a 6 s ie d i e M e s s u n g m i t e r p r o b t e n u n d z u v e r l i i s s i g e n 6 k o n o m e t r i s c h e n T e c h -

n i k e n g e s t a t t e n .

Trade Creation and Trade Diversion I6 9

Diese beiden Erfordernisse werden durch Konzepte eriiillt, die dem ~>Einkommens- effekt, und dem ~>Substitutionseffekt~ in der Theorie der he imischen Nachfrage /ihneln, wobei Handelsschaffung an die Stelle des ~>Einkommenseffekts~ t r i t t u n d Hande l sumlenkung an die Stelle des ~>Substitntionseffekts*. Diese Konzepte w a r d e n die Anwendung yon erprobten und verl/iBlichen MeBtechniken erlauben und t ro t zdem plausibel sein.

R d s u m d : La crdation de commerce extdr ieur et la diversion de commerce extdrieur: Les concept ions nouvelles et les mdthodes nouvelles de mesure. - - I1 a eu beaucoup des essais de mesurer les effets de la crdation de commerce extdrieur aussi bien qne de la diversion de commerce extdr ieur d 'une union douani~re, particuli~re- men t la Commnnau td Economique Europdenne et l 'Associat ion Europdenne de Libre-Echange pendan t une ddcade et demie. Mais il n ' y a gu6re un de ces essais que pour ra i t satisfaire. Une raison fondamenta le pas reconnue c o m m u n e m e n t est, peut-$tre, que la ddficience des concept ions dominan t e s de la crdation de commerce extdrieur et de la diversion de commerce extdrieur ne permet te pas une mesure s ta t i s t ique addquate.

C'est pourquoi ce sont des concept ions rdlevantes vis-a-vis les probl~mes du commerce extdrieur et des balances des pa i emen t s qu ' on doit ddvelopper, mais des conceptions qu ' on pent a jus ter pour satisfaire au crit~re de <,welfare,> global. Deuxibme- merit, les concept ions devraient sat isfaire aux mesures avee des techniques dcono- mdtr iques correctes et authent iques . Nous pouvons rempl i r ees deux exigences pa r des concept ions dtant similaires h d'effet de revenue>, et d 'effet de subst i tut ion~ des changes des pr ix de la thdorie de ddmande locale, la crdation de commerce extdrieur cor respondante ~ l'effet de revenu et la d ivers ion de commerce extdrieur corres- pondan te ~ l'effet de subs t i tu t ion . Ces concept ions rendra ien t possible des techniques de mesures correctes et consciencieuses sans m a n q u e r de la logique.

R e s u m e n : Creaci6n de comercio y desviaci6n de comercio: Nuevos conceptos, nuevos mdtodos de medici6n. - - H a n hab ido muchos in tentos pa ra medir creaci6n de comercio y desviaci6n de comercio en uniones econ6micas a t ravds de la filt ima d~cada y media, par t icu la rmente en la Comun idad Econ6mica Europea y e n la Asociaci6n Europea de Libre Comercio. Pero casi n inguno puede ser considerado como sat isfactor io. Una raz6n f u n d a m e n t a l c o m u n m e n t e reconocida p a r a este f racaso es, ta l vez, que los conceptos p reva lec ien tes de creaei6n de comerc io y desviaci6n de comercio t ienen defeetos y no p e r m i t e n ser medidos es tadls t ica- men te en fo rma adecuada. Lo que se requie re es, por lo t an to , desar ro l la r concep tos que sean r e l evan tes p a r a los p r o b l e m a s de comerc io y ba lanzas de pagos pero que t amb idn p u e d a n ser a ju s t ados p a r a c n m p l i r con los cr i ter ios de b i enes t a r global .En segundo lngar , los conceptos deberAn ser tales que p u e d a n ser s o m e t i d o s a mediciones con tdcnicas economdtr icas confiables y adecnadas .

Es tos dos r eque r imien tos son cumpl idos po r conceptos s imilares al <mfecto ingreso~> y al <~efecto sustituci6n~> de var iac iones de precios en la teor ia de d e m a n d a domdstica, donde creaci6n de comercio co r responde al <mfecto ingreso~> y des- viaci6n de comercio al *efecto susti tnci6n~. E s t o s conceptos se p r e s t a r l a n p a r a la aplieaci6n de tdcnicas de medici6n eonfiables y adecuadas sin que les fa l te una buena 16gica.

Trade creation and trade diversion: New concepts, new methods of measurement

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